Berkshire Hathaway: Worth Its SALT
Chart 1 below tracks Berkshire's "Adjusted Munger Value" quarterly since 1996 based on a simple method Charlie Munger referred to in his 1999 letter to Wesco shareholders. Charlie's method was simply book value plus one fifth of deferred taxes. Munger mentioned that each dollar of book value was much more valuable at Berkshire than a similar dollar at Wesco, but he did not say how much more valuable.
Munger explained how deferred tax could be thought of as an interest-free loan from the government that needed to be "repaid" only if Wesco sold investments and realized gains. Munger described his method as a guess but he did not explain fully why he thought one fifth was the right proportion.
So, Chart 1 tracks Berkshire's book value plus one fifth of float and deferred taxes, and multiplies the result by a premium that gets smaller as Berkshire grows relative to total US GDP. We call the resulting figure "Adjusted Munger Value" or AMV.
AMV matches pretty well with market price since 1996 showing five periods of over-valuation of 20% or more and five periods of under-valuation of 15% or more.
But there are those unanswered questions about how much a dollar of book value is really worth at Berkshire, and how much value accrues to shareholders from float and deferred taxes. So here is another approach.
Another Approach: Using Free Money
The point here is that Berkshire's $504bn of assets are partly funded by $60bn of deferred taxes, $79bn of insurance float and $131bn of other liabilities which are deducted to give book value of $234bn. (Book value is also called equity, same principle as homeowner's equity, it is total asset value less liabilities owed to others.) This is correct accounting but does not reveal the underlying economics. Until they are paid to those who ultimately own them, the deferred taxes and insurance float are earning returns for Berkshire. And the longer they earn money for Berkshire, the more they are worth to Berkshire's shareholders. (If you had an interest-free mortgage, repayable only in the far distant future (or perhaps never), how much would that be worth to you and how much to the lender? What if you had to repay it tomorrow?)
So it is really important to estimate how long Berkshire gets to use the deferred taxes and insurance float.
Berkshire's deferred tax liability arises mostly from unrealized gains on its investments and other property. The liability represents the tax Berkshire would have to pay (because of capital gains) if it sold those assets. But so long as Berkshire does not sell, there is no tax to pay and Berkshire can leave it all invested in income-producing assets.
Buffett's preferred holding period is "forever" and Berkshire's deferred tax liability has grown more than tenfold over the past eighteen years. Nevertheless, Berkshire does occasionally need to sell assets, and the amount of deferred tax also fluctuates with the prices of the stocks Berkshire owns. I guess that perhaps 85% can be considered very long-term funds.
The growth of insurance float has been more stable but could yet dip in a bad year. Insurance float represents premiums paid to Berkshire by its customers that Berkshire expects to pay out later to settle claims. Some claims get settled quickly, but provided the overall level of float does not fall, Berkshire gains from investing billions of dollars at a zero cost of capital.
In fact, Berkshire's insurance subsidiaries make an underwriting profit most years. That means they get paid to hold the float, giving a cost of capital even less than zero! Buffett said in the 2013 annual report that further gains in float would be tough to achieve but that, if there were any decline in float at some future time it would be very gradual.
So Berkshire should get to use the float for a long time.
Buffett also pointed out that the float came at a "price" of $17bn of goodwill that is included in book value as an asset. So we should perhaps make a corresponding downwards adjustment here but let us keep things simple and guess that 85% of float can also be considered long term funds. (By counting only 85% of float and deferred taxes we are already deducting $21bn. A further deduction for the $17bn of goodwill would reduce the calculated value of Berkshire by about 5%.)
Sustainable Assets Long Term - SALT
Chart 2 below plots the sum of equity plus 85% of float and deferred taxes against market price, a measure we call SALT.
There is a strong correlation between SALT and market price (R2 = 0.91) that I think is more than just coincidence. Berkshire's equity, together with 85% of its float and deferred taxes, can all be thought of as very long-term, non-interest bearing capital available for Berkshire to invest in what might be termed Sustainable Assets Long-Term or SALT. So long as Berkshire can deploy this capital at average rates of return, each dollar invested has a dollar of economic value.
This greatly simplifies the valuation. We do not need to guess what an average rate of return should be, nor make a host of other estimates that are prone to error. Instead we just need to think about Berkshire's businesses and investments. Can they do averagely well in future?
One point to bear in mind is that $55bn of Berkshire's assets are cash or equivalents earning low returns in US Treasury bonds. We have already set aside $21bn, in case of a bad year for insurance pay-outs, by counting only 85% of float and deferred taxes. But the other $34bn of cash, waiting to be deployed at above-average rates in the next acquisition, is a chunk of SALT currently earning well below average. But how little can $34bn of ready cash be worth, especially when you have so many clever people on your side constantly looking for profitable investments?
As a Berkshire shareholder, it is wonderful to think that Warren Buffett, Charlie Munger, Ted Weschler, Todd Combs, Ajit Jain, Peter Eastwood, Tad Mantross, Tony Nicely, Greg Abel, Matt Rose, Carl Ice, Ron Peltier, Louie, Ron and Irv Blumkin, Kevin Clayton, Jeff Pederson, Bill Franz, and many more of Berkshire's 330,000 employees are helping find best use for spare cash. As too are Berkshire's partners such as Jorge Paulo Lemann, Bernardo Hees, Alex Behring and all those clever people at Wells Fargo (NYSE:WFC), Coca-Cola (NYSE:KO), American Express (NYSE:AXP), IBM (NYSE:IBM) and others. Did I mention Bill Gates…?
So what do you think? Is Berkshire's array of above average businesses likely to prosper averagely well in the future? (Including the "…8 and a half companies that, were they stand-alone businesses, would be in the Fortune 500.") Are they worth their SALT? If so, Friday's closing price of $125.83 for the B shares ($189,279 for the A's) would seem to indicate that Berkshire was priced about 10% below intrinsic value. And if Berkshire's businesses continue to beat the average, we would then have a further margin of safety provided by the prospect of above-average future growth. That is what I think.
Disclosure: The author is long BRK.B. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.