Shares of Berkshire Hathaway (NYSE:BRK.A) are cheap. Really cheap.
As of the end of 2010, Berkshire had about $95,000 in cash and investments per class A share. In the 2010 letter to shareholders, Berkshire CEO Warren Buffett said he estimates the current after-tax annual earning power of Berkshire's operating businesses is about $12 billion, or about $7,000 per class A share. At Friday's closing price of $113,100, the market is valuing Berkshire's phenomenal operating businesses at less than 3x earnings after you strip out the cash and investments. This is absurdly cheap.
There are a variety of theories as to why Berkshire shares have traded down this year, and we're not impressed by any of them. Most people point to 'Sokolgate' and to potential reinsurance losses from the many natural disasters thus far in 2011. We think the Sokolgate issue is totally overblown. It doesn't affect the value of Berkshire today, and Sokol's departure isn't likely to materially harm its performance in the future. We also think the concerns about Berkshire's reinsurance businesses will prove unfounded. Berkshire's largest loss ever from any catastrophic event was $3 billion from Hurricane Katrina. Also, Berkshire keeps $20 billion in cash on hand at all times to pay out insurance claims. Berkshire's market cap has fallen by about $28 billion in the past few months. The market is effectively pricing in reinsurance losses more than nine times worse than those Berkshire suffered from Katrina. This is ridiculous.
So what's Berkshire worth? The math is simple. Let's value Berkshire's businesses at 12x their after-tax operating earnings. Arguably, this multiple is too low because of the wonderful quality of these businesses, but let's go with 12x for conservatism's sake. A 12x run-rate earnings of $7,000 per share is $84,000. Add to this the $95,000 in cash and investments, and we get a valuation of $179,000 per share. Also, Berkshire should continue to increase in value year after year, so this figure could easily be over $200,000 in a year or two, especially if Buffett makes another big acquisition. Even if Berkshire pays out $10 billion in reinsurance claims (probably far too high a sum), this value only goes down to $173,000. How do we know this methodology is sound? This is how Buffett values Berkshire himself, and we're not about to question the Oracle's ability to value a company.
Finally, a lot of people have concerns about succession at Berkshire. We think these concerns are irrelevant to valuing Berkshire today. The $179,000 per share valuation only gives Berkshire credit for the businesses and securities it already owns. Even if Buffett and Munger both passed away tomorrow and the company never made another investment, the shares would still increase in value as cash rolls into Omaha. Further, there's every indication that Buffett and Munger will be around for years to come, and as long as their successors avoid making really colossal mistakes, Berkshire will continue to grow impressively.
Eventually, Berkshire shares will trade to their fair value, and investors who buy shares today are likely to earn 50-60% when they do.
Disclosure: I am long Berkshire A shares (BRK.A).