Warren Buffett is a man who needs no introduction. The world's most famous investor credits his success to the teachings of Benjamin Graham, who developed the school of value investing that's still being practiced by millions decades after his retirement. Graham wrote The Intelligent Investor with the cautionary note that while his ideas and observations were relevant during his time, the future may bring about sweeping changes in the stock market that will render them invalid. We are now living in Graham's future, a future where stock transactions are facilitated by computer systems that execute at the speed of thought, where the Dow Jones Industrial Average has broken not only 1,000, but 10,000, and where his student is the head of one of the biggest multinational conglomerates in the world.
If Graham was alive today, would he invest in Berkshire Hathaway (BRK.A) (BRK.B)? To answer that question, we must first evaluate the company as Graham himself would and pin down Berkshire's intrinsic value - no easy feat, given the complexity and diversity of the company's operations. Investors and analysts have long debated on how to properly value Berkshire, each with their own models and formulas. Buffett himself has never divulged his own assessment of his company's intrinsic value, but fortunately for us, the Oracle has recently created a treasure map. That map is his 2010 annual letter to shareholders, and in it are the clues to this treasure hunt. Follow the clues, and you'll find the chest that contains Berkshire's elusive intrinsic value.
If you're the type of person who likes to solve riddles on his own, then you should stop reading now. For everyone else, here's the crib sheet with all the clues you need to find the prize:
- "I can estimate that the normal earning power of the assets we currently own is about $17 billion pre-tax and $12 billion after-tax, excluding any capital gains or losses."
- "In our reported earnings we reflect only the dividends our portfolio companies pay us. Our share of the undistributed earnings of these investees, however, was more than $2 billion last year."
- "In our earlier estimate of Berkshire’s normal earning power, we made three adjustments...At yearend we held $38 billion of cash equivalents that have been earning a pittance throughout 2010. At some point, however, better rates will return. They will add at least $500 million..."
- "At Berkshire, we...have pledged that we will hold at least $10 billion of cash, excluding that held at our regulated utility and railroad businesses. Because of that commitment, we customarily keep at least $20 billion on hand..."
These clues combined give the enterprising investor all the building blocks he needs to construct Berkshire's intrinsic value. As investors, we must never forget the fundamentals - indeed, Berkshire was built on the fundamentals. The most fundamental method of assessing a company's value is through its earning power, and this is just as true for a multibillion dollar conglomerate like Berkshire as it is for a lemonade stand, so that's where we'll start.
When valuing a cyclical company like Berkshire, we can't use earnings reported during a recession because it would understate the company's average expected earning power over the entire business cycle. Buffett estimates his company's earning power in a normal economic environment to be $12 billion after-tax...since the source is probably the most credible one on the planet when it comes to sizing up Berkshire, we'll use this figure as a baseline.
Investors know that Berkshire is more than its operating earnings, because a significant portion of its net worth is invested in its equity portfolio. Berkshire receives substantial dividends from its investments in blue chip stocks, which are credited to its income statement, but it also has a claim on a portion of its investees' retained earnings that's proportional to the size of its stake. Though these "hidden" earnings are not carried on the income statement, they still belong to Berkshire, so we must include them if we want to calculate Berkshire's true earning power. Buffett reports the value of these earnings to be "more than $2 billion," but we'll go with $2 billion to err on the side of caution. This figure is pre-tax, so in order to account for their true value to the company, we must subtract the tax Berkshire would have to pay if these retained earnings were instead paid out as dividends. Intercorporate dividends receive a 70% tax exclusion, so assuming we have to pay the standard 35% rate on the remaining 30%, the retained earnings of Berkshire's equity portfolio add a total of $1.79 billion to the company's earning power.
Now we arrive at cash. Buffett said that he would like to retain $20 billion at all times to buttress Berkshire's fortress balance sheet, which leaves $18 billion of extra funds on the table. This cash will likely be reinvested back into the business or spent on an acquisition, so rather than valuing it as an income-generating asset, we should value it at book. To proceed, we have to subtract its earning power from our equation: 18/38 x $500 million = $237 million.
And that's it. Berkshire's total normalized earning power is: $12 billion + $1.79 billion - $237 million = $13.553 billion. The average P/E for the S&P 500 has been 15 over the past century, so we'll apply that as a multiplier to calculate Berkshire's fair value market cap: $13.553 billion x 15 = $203.295 billion. Add in cash of $18 billion, and we arrive at a total market cap of $221.295 billion.
But wait! We're not done yet. Buffett penned that letter after fiscal year 2010, and we're now one fiscal quarter down the road. That's one quarter that Berkshire's had to grow its value. Berkshire didn't have a strong showing last quarter and earned only $1.511 billion in after-tax profit, but we'll add that into our final sum anyway.
The hunt is now complete, and we have our treasure: Berkshire Hathaway's intrinsic value stands at $222.8 billion for the entire company. That's $135,164.10 per Class A share, and $90.10 per Class B share.
Our exercise now complete, we return to our original question: would Benjamin Graham invest in Buffett's Berkshire Hathaway today? Graham liked to buy companies when they're trading at a third below their intrinsic value or less, believing that such opportunities retain an appropriate margin of safety for the conservative investor. At Thursday's closing price of $112,336 per Class A share and $74.85 per Class B share, Berkshire is trading at roughly 83% of its intrinsic value. This does not meet Graham's criteria for an investment-grade stock, and though he would no doubt be a big fan of Berkshire and its CEO, he would most likely not invest in it.
Warren Buffett, on the other hand, has always said that he would rather buy a great company at a fair price than a fair company at a great price. Berkshire's stock today represents the opportunity to buy into a great company at a pretty good price, so while Graham may not invest, Buffett would. That is, if he didn't already own $40 billion worth of shares.
Disclosure: I am long BRK.B.