Berkshire Hathaway Looks Overextended

May. 2.14 | About: Berkshire Hathaway (BRK.A)

Summary

Berkshire Hathaway's valuation has become very stretched in the past year or so.

Earnings estimates are far too low to justify $129 per share.

Berkshire will need to beat current earnings estimates by nearly 600 basis points per year in order to justify $129.

Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) needs no introduction. It is the empire built by one of the greatest investors of all-time and it has minted many millionaires in the past few decades. Berkshire is often looked at as a market proxy as it is highly diversified in its holdings including wholly owned subsidiaries and common stock positions. With indices at all-time highs it begs the question: is Berkshire too expensive? In this article we'll take a look at Berkshire's valuation in order to see if perhaps it has been stretched too far by recent equity gains.

To do this I'll use an earnings model you can read more about here. Basically, I select inputs such as earnings estimates and a cost of capital in order to estimate what Berkshire's fair value is today based upon its expected earnings stream in the coming years. And since Berkshire has two classes of common stock outstanding, I used the B shares due simply to the lower numbers being easier to work with. The results of this analysis are below.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$6.14

$6.35

$7.28

$7.85

$8.46

$9.12

x(1+Forecasted earnings growth)

3.42%

14.70%

7.80%

7.80%

7.80%

7.80%

=Forecasted earnings per share

$6.35

$7.28

$7.85

$8.46

$9.12

$9.84

Equity Book Value Forecasts

Equity book value at beginning of year

$94.93

$101.28

$108.56

$116.41

$124.88

$134.00

Earnings per share

$6.35

$7.28

$7.85

$8.46

$9.12

$9.84

-Dividends per share

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

=Equity book value at EOY

$94.93

$101.28

$108.56

$116.41

$124.88

$134.00

$143.84

Abnormal earnings

Equity book value at begin of year

$94.93

$101.28

$108.56

$116.41

$124.88

$134.00

x Equity cost of capital

7.28%

7.28%

7.28%

7.28%

7.28%

7.28%

7.28%

=Normal earnings

$6.91

$7.37

$7.90

$8.48

$9.09

$9.76

Forecasted EPS

$6.35

$7.28

$7.85

$8.46

$9.12

$9.84

-Normal earnings

$6.91

$7.37

$7.90

$8.48

$9.09

$9.76

=Abnormal earnings

-$0.56

-$0.09

-$0.05

-$0.01

$0.03

$0.08

Valuation

Future abnormal earnings

-$0.56

-$0.09

-$0.05

-$0.01

$0.03

$0.08

x discount factor(0.0728)

0.932

0.869

0.810

0.755

0.704

0.656

=Abnormal earnings disc to present

-$0.52

-$0.08

-$0.04

-$0.01

$0.02

$0.05

Abnormal earnings in year +6

$0.08

Assumed long-term growth rate

3.00%

Value of terminal year

$1.88

Estimated share price

Sum of discounted AE over horizon

-$0.63

+PV of terminal year AE

$1.23

=PV of all AE

$0.60

+Current equity book value

$94.93

=Estimated current share price

$95.53

Click to enlarge

As you can see, my model produces a current fair value of only $95, compared to the current share price of $129, an enormous disparity. However, I believe the model still has some value. It is important to understand how the fair value was obtained in order to decide if Berkshire is a good value at today's prices.

I used earnings estimates linked above as a baseline scenario for Berkshire shares as they seem reasonable enough. Current estimates assume roughly 8% earnings growth per annum and while that may or may not be the right number, it is certainly plausible given Berkshire's track record. The company famously pays no dividends so that was an easy line item to forecast. The perpetual growth rate I used was 3% and for the cost of capital, I used the company's beta of .39, the 10 year Treasury as the risk free rate and an equity market premium of 12% to come up with the value seen.

It is important to understand the model is not producing a price target; rather, it is producing a fair value for shares, which is the discounted present value of future earnings based upon all the inputs I described. Thus, with the inputs I used Berkshire is currently worth about $95 per share. In fairness, the model penalizes companies that don't pay dividends as fair value is a function of earnings on the net assets, or book value of the company. However, that doesn't change the fact that Berkshire is expected to grow book value by only 8% per year going forward and when you apply even a modest discount rate, the fair value of the company grows very modestly.

I know what you're thinking; Berkshire is run by a legend, a genius in the investing community, and you're right. Berkshire has a "Buffett premium" wherein shares are worth more because the Oracle always finds a way to make money. If this company were exactly the same but run by a "normal" CEO, I'd suggest it would be worth substantially less than it currently is. However, that doesn't mean you should overpay for shares.

With equity markets at all-time highs the case can be made they are overextended but at the very least, they certainly aren't cheap. With Berkshire so tied to the economy as a whole given its holdings and the fact that it is trading for a robust 18 times next year's earnings estimate, I'd suggest Berkshire is overextended as well. The Oracle will still make plenty of money next year but I think Berkshire has come too far to represent a good value at $129.

Just for giggles, I altered my model's earnings estimates to produce a fair value of $129, matching today's actual share price. The earnings growth rate required to produce such a price is 13.5% per annum, or almost double what Berkshire is expected to do. Pricing in 13.5% earnings growth for a $300 billion company seems a bit high to me and further cements that if you want to be long Berkshire, you should wait. Shares are not a good value right now and I suspect that if Buffett wasn't running Berkshire, he wouldn't be buying shares at these prices. Berkshire is a world class company but that doesn't mean you should overpay for the right to own it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.