In Warren Buffett’s 2010 annual letter to shareholders, the section “On Reporting and Misreporting: The Numbers That Count and Those That Don’t” emphasizes against using net income to value Berkshire Hathaway (BRK.B). This is primarily because the company has the flexibility to allow net income to be any number, as it can realize gains by liquidating investments with large unrealized gains. The section further guides the reader to focus on the operating earnings and book value to judge Berkshire’s performance. In the same letter, the section “Intrinsic Value – Today and Tomorrow” provides further clues on how to evaluate Berkshire’s business. In essence, Berkshire’s intrinsic value consists of the following three items, of which only the first two can be calculated: Value of investments; earnings from sources other than investments and insurance underwriting; and efficacy with which retained earnings will be deployed in the future.
Over the last few months, numerous analysts have attempted to value Berkshire Hathaway using Buffett’s clues. Inevitably they initiated a lively discussion debating the finer details of the valuation method employed and the assumptions made. Concerns in valuing Berkshire Hathaway as a sum-of-parts that include non-insurance operating earnings and investments include placing a value on the float insurance companies maintain, which is more of an art than a science; and the fact that Berkshire has historically generated returns well above average on retained earnings. Given the size of the portfolio and the succession issue, it is impossible to predetermine future performance of the portfolio.
Traditional methods of valuing businesses involve arriving at accurate figures for some key metrics including net earnings and growth rate. For insurance businesses, net earnings normally fluctuate depending on claims activity. The effect of adding the realized gains Buffett mentioned is further to this. Over time, such variables get smoothed. Below is a look at Berkshire’s net earnings over the years along with realized gains taken from the annual reports.
Although the net earnings number has varied vastly, in a 15-year span Berkshire exhibits an increasing trend. Over the years, roughly a third of the earnings Berkshire Hathaway has booked are realized gains, even though the gains/losses for any given year are quite random.
This spreadsheet shows some key numbers along with fair value estimates for Berkshire Hathaway stock (click here for an understanding of the formulas involved).
A way to account for fluctuations in net earnings is by using a normalized net earnings number in place of the reported net earnings number. The fair value estimates above have used the reported number; the normalized number would be a little bit higher and using that would have resulted in higher fair value estimates, so the valuations in the spreadsheet are fairly conservative.
Berkshire Hathaway valuation using PEG based model
The model shows a fair value of ~$52K, about ~50% below current BRK.A market price. The formula is limited in many ways, including the use of dividends as a way of valuing mature businesses with slower growth rates. To arrive at the net earnings growth rate used in the formula, we looked at the compounded annual growth rate of Berkshire Hathaway going back 20 years.
The spreadsheet indicates a drop in CAGR for the past five years compared to the last 10 or more years. Consequently, the growth rate for the last five years was rounded off to arrive at a conservative earnings growth number of 7.
Given the size of Berkshire Hathaway’s cash and investments at over $150 billion, it is evident that the company could easily afford issuing a generous dividend. The company’s stated goal is to be in the business of shooting for above average returns on retained earnings. Below is a look at fair value estimates when varying the dividend yield number from 0 to 5%.
Benjamin Graham Model
This model shows a fair value estimate of ~$147K, about ~40% above current BRK.A market price. The variables in the formula are the EPS number, the current yield of AAA corporate bonds, and the seven-to-10 year projected earnings growth rate number. The former two are absolute numbers, so accurately determining the earnings growth rate number is vital to this formula. Below is a look at fair value estimates when varying that number between the long-term US growth rate of 2% and the long-term growth rate of Berkshire (19 years, ~17%).
The Discounted Cash Flow-based model
The fair value estimate of this model is ~$259K, about ~140% over current BRK.A market price. The variables in the formula are the fivce-year and the long-term earnings growth rate along with the discount rate that is set as the weighted average cost of capital of the company. The model uses present value estimates for all future income which relies on the discount rate. Berkshire Hathaway’s value for that number is an outstanding 5.92%, which accounts for the high present values of future earnings, which in turn is reflected in the fair value estimate. Here is a look at fair value estimates when varying that number.
Although Buffett has indicated that using operating earnings of non-insurance businesses and value of investments as a good starting point to evaluate Berkshire, arriving at an accurate fair value still involves valuing the float and assuming a rate of return for the retained earnings in the future. Traditional methods of assessing Berkshire are problem-ridden due to the erratic nature of an insurance business and the fact that the company’s earnings can vary depending on whether investment gains were realized during the period involved. Even so, as these variations lose their edges over time, it is still possible to apply traditional methods to arrive at a range of valuations. Such analysis can be a valuable tool to assess the risk and reward when investing in Berkshire stock.
Our analysis based on the popular models to calculate fair value largely indicates a significant undervaluation in the market price of Berkshire stock. As such, the current price is a great entry point for investors intending to go long.
Disclosure: I have written cash-covered puts on Berkshire Hathaway (BRK.B Jan 2012 75) stock.