Berkshire Hathaway (NYSE:BRK.B) is Warren Buffett's holding company where he keeps all the major companies he's been buying over the past 50 years. Although it is well diversified among many industries there is a lot of legacy investment in the financial and insurance sectors. This includes Geico and the Reinsurance arm that covers major one-off policies. These insurance groups collect a lot of premiums that can be invested for many years until they have to be paid out.
These premiums are the foundation of a unique structure not found in other insurance companies. Most insurance companies invest in easy-to-value securities like bonds. Instead of this, Buffet uses the premiums he receives from insurance policies to buy safe but profitable operating companies such as BNSF railway, Duracell, Fruit of the Loom, and Business Wire. Additionally Berkshire is the largest shareholder in many other household names. Wells Fargo (NYSE:WFC), American Express (NYSE:AXP), Coca-cola (NYSE:KO), and the new merged Kraft-Heinz (NASDAQ:KHC) deal.
These companies are already doing fine on their own but are a bit boring. No one is going to revolutionize anything at Kraft. That's perfect for using the Discounted Cash Flow method to find an approximate value. It's best used on series of cash flows that can be estimated with precision far into the future. Since all of these investments were chosen for their longevity by several good investors, we can safely use it.
Enterprise life and earnings growth:
Many people try to value Berkshire Hathaway by adding up the value of all its component parts. That would be fine if it was being broken up and sold for some reason. However, a lot of the value comes from its structure as a hybrid insurance and holding company, where insurance premiums are invested in the operating side.
Another even more obvious reason to value Berkshire Hathaway as a single entity is that it's run by one of the best investors in history. Since Warren Buffett is directing where the insurance premiums are invested that has a large effect on its value. But he won't be around forever. Any valuation that does not break up the company implicitly includes an estimate of his subordinates investing ability.
I believe that Buffett is a good manager of people and therefore Ajit Jain, Todd Combs, and Ted Weschler can be trusted to perform similarly in the future. Although they may not increase book value at 20% every year.
Because of its exceptional financial strength now and future management prospects, I think earnings will grow at around 7.5% per year for the next 20 years. They have been growing at an average of 9.6% over the past 10 years, so 7.5% is a relatively conservative approximation. Also I assume that earnings will grow at 4% for a further 10 years after that. No more earnings are expected for the purposes of this valuation.
Calculating the correct discount rate is also important, since Berkshire Hathaway's investments are less risky than average. The Beta varies depending on who is measuring it. Google Finance has it at 0.82. Yahoo Finance has it at 0. Morningstar has it at 0.92.
I think 0.85 is a good middle of the road estimate, which gives us a discount rate of 10.7%.
Discount rate= risk free rate + equity premium x Beta
10.7%= 3% + (12% - 3%) x 0.85
I use the Discounted Cash Flow calculator at Gurufocus.com to quickly and easily value stocks. It performs the same steps as a financial calculator would. Here are the variables I enter:
Current 12 mo EPS= 9.23
Growth rate= 7.5%
Terminal growth rate= 4%
Years of terminal growth= 10
Discount rate= 10.7%
At the time of publication. BRK.B was trading between $127 and $131. This leads me to believe it is at least 25% undervalued. Purchasing it would be a good investment for someone with a long-term time horizon. Because Buffett and his partners routinely purchase out-of-favor companies, it may take 5 to 7 years for their value to be noticed by the marketplace. Like many things in life, this is a good idea that requires patience.
Please leave comments below. Let me know whether you think EPS is appropriate for valuing such a complicated conglomerate. Maybe NOPAT or "owner earnings"? Also if you have a valuation, please include your method of estimation.
Disclosure: I am/we are long BRK.B.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article was written for informative purposes only, and is not a solicitation to buy or sell securities. Please do your own research or consult a financial advisor before making any investment decision.