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I read Whitney Tilson's evaluation of Berkshire (NYSE:BRK.A), but with all due respect, I do not agree with Berkshire being valued at $178000/share or at a market cap of $290 billion. Tilson's valuation of Berkshire's equity = $98,366/share + $8000 x 10 = $178,366/share assumes no debt and other liabilities. But if liabilities are considered, then all liquid investments cancel out the debt and liabilities. In my opinion, Berkshire is not mispriced but rather appropriately priced, based on the 2011 annual report. My reasoning is below.

We know that:

Total market cap = Enterprise Value + Non-Operating Assets

(** The above equation works for complete business buyout **)

Berkshire Hathaway

EQUITY

(in Billions)

Current Market Cap

$195

Liabilities

Notes Payable

$60.39

Loss Adjustment Expense

$63.80

Unearned Premium

$8.90

Life and Health Insurance Benefits

$9.90

Derivative Contract Liabilities

$10.13

Deferred Taxes

$37.80

Total Liabilities

$191

(** Numbers have been rounded to two decimals; The liabilities are at book value and are assumed to mirror their market value**)

a) Free Cash Flow = approximately $15B/year (includes interest, dividends, Free Cash Flow from privately-held companies; Lubrizol numbers are considered for full year)

b) Liquid Investments = approximately $162B (this includes cash, fixed income, equity investments etc. from all three segments)

Now we input the value in the equation:

Total market cap = Enterprise Value + Non-Operating Assets

Market Value of Equity + Market Value of Liabilities = PV(Sum(Free Cash Flow)) + Non-Operating Assets

$195B + $191B = PV(Sum(Free Cash Flow)) + $162B

So PV(Sum(Free Cash Flow)) = $224B ……………………(1)

Free Cash Flow Description:

Current Free Cash Flow equals approximately $15B (after including Lubrizol for full year). This Free Cash Flow can be split into two parts namely:

Free Cash Flow (interest, dividends etc) + Free Cash Flow from privately-held companies

$4.8B + $10B = $14.8B or approximately $15B/yr of Free Cash Flow.

[The above numbers say that if you have to buy Berkshire completely then you would need $386B. After paying $386B you will get $162B in liquid investments that generate $4.8B dividends and interest, and all privately-held companies generating Free Cash Flow approximately $10B/year (including Lubrizol).

Thus, Free Cash Flow Yield (i.e. if complete Berkshire (BRK-A) is bought) = $15B/ $386B = 3.88%

AAA rated bonds have a yield of 4% to 5%. When Berkshire is compared to fixed income then Berkshire's yield is less than AAA rated bonds. Berkshire is trading at a Free Cash Flow multiple of 25.7 when liabilities are considered.

Discussion Points:

  1. Since privately-held businesses are generating $10B/yr and interest income and dividends generate $4.8B/yr, the money can be used to pay out debt (notes) in next 5 years, which will increase the Free Cash Flow Yield.

My Reply: This will happen in next 5 years and the value of Berkshire will increase. But at present the price of Berkshire (both BRK.A and BRK.B) fully reflects its value.

  1. Around $70B liabilities are of float and the future premiums should cover those losses and hence should not be considered in liabilities.

My Reply: I would still consider them as a liability. You never know when the earth shakes or the clouds rumble. This is true for derivative contracts as well. Until the contracts do not expire, it's advisable to consider derivative contracts as a liability.

Relative Comparisons:

Price/BV

ROA

ROE

Progressive (NYSE:PGR)

2.3

5.2

17.7

Fairfax

1.1

0.8

0.6

Berkshire

1.2

3.2

7.06

The ROE of Berkshire is low in comparison to Progressive. This is true for the last 10 years. Progressive, being much smaller, is better able to use its float and hence generates more Free Cash Flow on per equity basis. Some of the problems with Berkshire are:

  • Size

  • Investment such as Coke, even though being good, is not financially optimal. This in turn saddles the return on equity.

Final Thoughts:

Berkshire is slowly moving away from being an insurance company (which holds liquid investments) to one having a mix of liquid public investments and privately-held companies. At present, with Free Cash Flow ~ $15B/yr, it should be valued close to its liquidation i.e. book value.

The valuation change will happen as the Free Cash Flow increases due to efficiently run private businesses (some of them run at 60% ROE) but that change will happen in the next 3 to 5 years. I do not see that within one year the equity valuation will reach $290B (or total market cap of $481B) unless the market reaches the internet bubble era or Buffett buys a few more companies. Overall, it's a safe bet on the growth and efficiency of privately-held companies, but it's not mispriced.

Source: Berkshire Hathaway Is Not Mispriced