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First of all, I confess to being a disciple of Graham and Dodd investing. Margin of safety, buying below book value, focusing on returns on equity (ROE), sustainable moats, etc., all make tons of sense to me. And frankly, this value style has served me well over the years. So, given Warren Buffett’s recent announcement to buy back shares, and some glaring errors in evaluating this stock that I have also seen out there, I took a dive into Berkshire Hathaway (BRK.A)(BRK.B) this week to determine how cheap this stock really is.

Basics:

  • Company: Berkshire Hathaway, tickers BRK.A, BRK.B
  • Chairman: Warren Buffett, 23% holder of Berkshire stock, 81 years old
  • Price: A shares, $106,500, B shares $71 (1500 B shares per A)
  • Shares: 2.48BB equivalent B shares
  • Market Cap: $176BB
  • Book Value: $167BB at June 30, 2011
  • Price/Book: 1.05x

The Business:

Essentially Buffett used to run Berkshire Hathaway as an investment company, buying cheap equities with the float from his insurance businesses, and generating solid returns via stock gains. Berkshire eventually got so big however, that he was forced into the private equity business. Buffett acquires control stakes, sometimes buying blocks of public stock that ultimately led to buying entire companies. Looking at the balance sheet, roughly half of the company is invested in public securities, cash and fixed income, and the other half in wholly owned companies. Like any insurance company, the critical success factors are ROEs, careful underwriting, and the performance of his investment portfolio (which ties to ROEs of course). Among his control positions, it’s not that different: ROEs, FCF, and sustainable growth are paramount.

Breaking Apart the Balance Sheet:

This is the nuts and bolts of valuing Berkshire in my opinion. He has a portfolio of stocks, bonds, and “Other” assets which mostly are preferreds on the balance sheet, and valuing these isn’t so difficult really. Starting with equities, BRK owns $67.6BB of public equities on the balance sheet as of June 30th. They are fully marked to market, and it’s pretty straightforward. What I think is important is to mark them to today’s prices, again pretty easy and here is what we get:

Shares (mms)

Value ($BB)

KO

200

$14,162

WFC

359

$7,867

AXP

152

$6,328

PG

72

$4,621

KFT

97

$3,279

JNJ

45

$2,758

MUNICH RE

19

$2,197

WMT

39

$1,978

COP

29

$1,558

SANOFI

26

$1,557

USB

78

$1,789

POSCO

4

$1,326

TESCO

242

$1,284

MCO

29

$681

$51,385

These are only his positions over $1BB in size, so some are left out. The value on the balance sheet as of June 30th of these above names was $54.8BB, indicating losses of $3.45BB since quarter end. That is down 6.3%, which isn’t bad considering the market is down 12% since quarter end. Extrapolating similar losses to the entire $68BB book implies Buffet has lost $4.25BB since then, give or take.

As far as his cash and bond portfolio, I would suggest that he hasn’t really lost much money there. Treasuries have rallied, so have investment grade bonds, plus he holds tons of just pure cash. Considering that 86% of Berkshire’s non-treasury bond book is AA rated or higher, I think it’s unlikely that there has been any real damage here. Arguably he is up this quarter. So, I leave the $36BB of fixed income investments at its June levels. The pure cash he has, $47.8BB, clearly is still worth $47.8BB.

Finally, the $13BB in the “Other Asset” category mostly includes his preferred stock investments. These are in General Electric, Goldman Sachs (actually redeemed now), Wrigley’s (which also includes some notes), and eventually his Bank of America preferreds. He marks these as held to maturity, and fair value is actually $1.1BB higher than where he has marked as of June 30th. For conservatism’s sake, I’ll assume fair value remains the $13BB value as of quarter end.

So investment assets excluding the operating businesses, total $160BB. That is marked to market as close as I can come up with. For the B shares, that is $64.65 per share. Hold on before you make any generalizations like, “At $71, I am getting all of the operating businesses for almost nothing.” Not correct. Keep reading.

Operating Businesses

This is where it gets tough. Buffett has bought so many businesses, and they are all marked at cost, that going through each one and putting a multiple on it is probably fruitless. His biggest deal, which closed in 2010, was Burlington Northern. He paid $34BB in total equity value for it, and it’s been a very good addition to BRK. Railroad stocks trade so far below replacement cost, that you could never replicate these businesses. Limited supply of new capacity, cheaper cost per mile compared to trucking, solid ROEs and cash flow make this a perfect Buffett fit. ROEs, moats, longevity, Burlington’s got them all.

Looking at some numbers, if you take his last quarter’s results, annualize them, and throw in a 35% tax rate, then it looks like Burlington will generate at least $2.8BB in net income this year. At 13.5x, about where Norfolk Southern trades, implies he has made $3.6BB on this deal. And historically, railroads trade between 10 and 18x earnings, so there is clearly multiple upside too. Not that he plans to sell it ever, but it’s important in this analysis.

Another of his bigger companies, Geico is marked on the balance sheet at $4.6BB. Yet this company generated $650mm in net income last year. At 14x, it’s under-marked by probably $4.5BB. This exercise, if continued would be very illuminating, but clearly to me there is almost $8BB+ of under-marked value in these 2 businesses alone.

My Approach to Value the Owned Businesses

Cutting to the chase, I think perhaps the best way to analyze the operated businesses is to aggregate earnings, and assume an appropriate FCF yield, or P/E multiple. Generally, here is what I did:

  1. Excluded the investment gains and losses from earnings.
  2. Took the last quarter and six months, and extrapolated what 2011 earnings would look like. In Q2 for example, pre-tax income was $2.9BB.
  3. Took out $400mm of catastrophic losses from the first half of 2010, which skewed the numbers to some extent.
  4. Added Lubrizol’s potential $1BB of pre-tax earnings, as this deal will likely close soon.

Business segments operating results PRETAX excluding inv income

$2,912

Annualized

$11,648

Add Lubrizol

$1,000

Add back cat losses in H1 2010, 400mm

$800

Pre tax non investment businesses

$13,448

After tax non investment businesses

$8,741

After tax non investment businesses, per B Share

$3.53

This gets us a 2011 EPS estimate of $3.53 on BRK B shares at least. Obviously it would amount to $5,294 of EPS of the A shares.

Intrinsic Value

The famous Intrinsic Value of Berkshire Hathaway is clearly Buffett’s way of looking at his company. I think this is the most telling paragraph from his letter to shareholders last year, and gives us a sense for how he defines intrinsic value:

“A “normal year,” of course, is not something that either Charlie Munger, Vice Chairman of Berkshire and my partner, or I can define with anything like precision. But for the purpose of estimating our current earning power, we are envisioning a year free of a mega-catastrophe in insurance and possessing a general business climate somewhat better than that of 2010 but weaker than that of 2005 or 2006. Using these assumptions, and several others that I will explain in the “Investment” section, 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. Every day Charlie and I think about how we can build on this base.”

Taking Buffett at his word (not an exercise of faith in my opinion), lets determine what EPS would be.

After tax non investment businesses

$12,000

After tax non investment businesses, per B Share

$4.84

This is a lot higher than the $3.53 in EPS that I came up with. 2011 hasn’t been great for Berkshire’s companies. Some of it is the catastrophes this year, some is underperformance of the economy and some probably due to continued weakness in housing. Either way, when Buffett announced his share buyback plan last week, he did so with the idea that a recovery in the US economy may not happen this year, but in 2013, or 2014, when we’ll have a much rosier scenario than today. One where Berkshire’s operating businesses can generate normalized earnings per B share.

Liabilities

Buffet has piles of cash, but a lot of this is the float. That is, much of the cash sitting on the balance sheet is derived from paid insurance premiums. Because of this, you cannot ignore the future policy claims of $65BB. These can change somewhat year to year as reserve get adjusted slightly, but generally, you have to net these against the investment assets.

Assets, $160BB, less $65BB in liabilities subtotals a cool $95BB in net assets.

Finally, I would probably re-mark Berkshire’s index puts that he sold. Here is the math on them today.

  • Notional: $35BB
  • Estimated Strike: S&P at 1400
  • Time entered into contracts: 2006-2007
  • Expiration date (average): 2024
  • Net liability on balance sheet: $6.7BB (marked to market losses recognized to date)

So he received $4.9BB in premium for very long dated at-the-money puts on the S&P. He unwound 8 of the 47 puts in 2010. The latest 10Q shows that $35BB are left, with a liability of $6.7BB as of June 30th. So if the S&P is at 1000 in 2024, down 15% from today, then future liabilities would be about $3.3BB higher than marks today. That's would be only a 1.8% hit to the stock. If the market is at least 1400, then he'll have $6.7BB in gains to realize. Not a concern to me, seems more upside than downside. Although there may be $1-2BB in marked to market losses this quarter, in this case I think it's too early to really ding Berkshire here.

Finally, since I included Lubrizol in the EPS numbers, you have to take that $9BB out of existing cash.

Net net, I calculate the subtotaled $95BB less $6.7BB (puts) less $9.0BB (Lubrizol deal) = $79.3BB. That means we have net investment assets and cash of $30.30 per B share or $45,450 per A share.

Valuation

So where does that leave BRK in terms of a FCF yield or implied P/E multiple?

  • Stock Price (B’s): $71.00
  • Less Cash & Inv per Share: $30.30
  • Net price for Operating Co’s: $40.70
  • EPS B Shares: $3.53
  • P/E Implied: 11.5x,
  • FCF Yield: 8.7%
  • S&P Multiple Today on 2012: 11.6x

On the surface, the stock is trading almost exactly in-line with the market and suggests it's at fair value. This makes a lot more sense to me than the bulls throwing out 10x multiples for BRK’s operating businesses, excluding their policy liabilities, and getting values on the stock of well north of $100-110 bucks a share. If I am wrong in how I compute this, then please comment and let me know why they should be excluded. There is simply no chance that the stock at a 10x multiple equates to upside of 50% or something crazy. Markets are not that easy.

BUT ...

As Buffett looks at his company’s intrinsic value, he believes EPS after tax can be almost $5. Let’s use $4.75, just a tad below his estimates for normalized earnings. Keep in mind this is without Lubrizol, so fairly conservative. Let’s also make one adjustment, and that is the following:

S&P earnings and P/E numbers are calculated on an adjusted basis. Plant closures, severance, and non-recurring charges to earnings in the form of other asset write downs are all examples of charges excluded from S&P EPS figures. So, I took a look at the Q2 unadjusted EPS figures for the S&P. And that number was $22.22 in quarterly unadjusted EPS compared to adjusted EPS of almost $25/share in the quarter. That means that true S&P multiples should be based on $89 in annual EPS for the S&P index, not $99. I do this because you never see any adjustments to Berkshire’s earnings. They are what they are, unadjusted.

Using a 13x P/E multiple on $4.75 in EPS looks like:

  • P/E: 13.0x
  • EPS: $4.75
  • Value: $61.75
  • Plus cash & investments: $30.30
  • Intrinsic Value per B Share: $92.05

That is 31% higher than the current share price. I think Buffet believes he can buy this at 20% below intrinsic value, and that that is a good price. That also implies he can buy back stock at a price per share that is roughly 110% of current book value. Hence the level on the share buybacks. Don’t forget, you can also look out 12 months from today, whereby another $12BB of cash will likely roll into Omaha. That equals almost $5 more in value per share. That gives you a one year total potential stock price of $97, or upside of 37%. That is my 1-2 year upside case. To get there, though, you need a decent US economy, at least in 2012 or 2013. The odds of a downside case are probably just as high.

Downside

The U.S. economy is under pressure. That said, the stock has dramatically underperformed this year with the David Sokol scandal and the lack of positive catalysts. Catastrophes have also made a few dents here and there. Many investors equate buying BRK with getting long the US economy. Probably true. However, the stock is down 14% over the past year, vs. the S&P down less than 1%. I suspect that with up to $27BB of cash available to buy back stock, there will be significant support near term.

Part of me wonders why he has initiated this buy back at all. My guess is that one of his new investment managers, Todd Combs or Ted Weschler who just joined, perhaps persuaded Buffett to consider a buyback. Why pay 12-15x for a big acquisition, when you can spend huge sums buying back your own stock for 10-11x? The logic is sound. And with over $1BB in cash flooding the company’s coffers every month, there will be ample cash to do a big acquisition if he wants, as well as buy back his own shares.

But to get to the downside, in 2008 book value fell 10%. We have already illustrated $4-6BB in losses from the investment side of the business. Profits on the operating businesses could fall too. In fact, in 2008, EPS for the A shares was negative $7.5BB. A similar fall today would put book at $61/share, which I consider a reasonable downside case. That is down 14%. The risk reward seems pretty decent to me, up 37%, down 14%.

Conclusion

This is a complex company to analyze. I think the stock is pretty cheap. But you cannot evaluate it with the hope that it will ever attain previous historical price to book ratios. I think it will hover between 1.0x and 1.25x book, far from its glory days of 1.5 to 2.0x book. It is just too big to trade better. Naysayers to the stock may point out that BV/share didn’t keep up with the market in 2009 and 2010, but I would counter with a more relevant 5 year time frame, whereby book value per share beat the S&P by 5.34% on average per year. That may not sound like much, but that means BV/share grew cumulatively 60% from January 2006 through the end of 2010, versus the S&P which grew only 12% cumulatively over the same time frame. If you own S&P index funds, then I would just ask, why?

Finally, BRK stock can and probably will get cheaper as the economy peters out and Europe faces ultimately what will be a panic-inducing sovereign debt restructuring. But you can be reasonably sure that with so much cash behind it, the underperformance of this stock will end, and likely in a solvency crisis Buffett will step in to add to the portfolio significant investments at high return type levels. Heads you win, tails you don’t lose.

Source: Berkshire Hathaway: Is It Really That Cheap