Berkshire Hathaway: How To Close The Valuation Gap

May.11.12 | About: Berkshire Hathaway (BRK.B)

This past weekend I had the pleasure of attending the Berkshire Hathaway (NYSE:BRK.B) Annual Meeting. A common theme discussed at the meeting is the fact that Berkshire Hathaway is significantly undervalued. I believe much of this undervaluation is due to Buffett's age (he's 81 years old) and the fact there is no publicly defined succession plan.

At the meeting, Warren Buffett indicated that on average, over the past 35 years, the company has sold at its intrinsic value. Below is a chart illustrating Berkshire Hathaway's 'A' Shares price to book value and its stock price since 1980:


(Click to enlarge)

During this time the average and median price to book ratio has been 1.60. Berkshire Hathaway's most recent closing price was at a price-to-book value ratio of 1.15. This is towards the low end of its valuation range since 1982. Assuming Warren is right about Berkshire Hathaway's intrinsic value, the shares trade at a 28 percent discount to its intrinsic value. As a result, they have 39.1 percent upside to its average and median historical price-to-book value ratio. The company has publicly indicated they will engage in open market stock repurchases when the shares trade at 1.10 times book value. Assuming the company would aggressively repurchase shares at this level, it implies downside risk of 4.3 percent. My estimated upside return potential that is 9.1 times greater than my estimated downside risk. Statistically, the stock is very attractive. However, the stock needs a catalyst to close its valuation gap.

I believe removing the uncertainty with Buffett's successor would help close this gap. I believe the board should publicly name Buffett's successor at a highly publicized news conference. Buffett should then mentor this individual and introduce him to his wide network of individuals and companies. One of Berkshire's biggest competitive advantages is the ability of Warren to pick up the phone and call an individual or company to make an investment on attractive terms for Berkshire. Having Warren's successor privy to this information would be in the best interest of shareholders. It is the fiduciary duty of the Board to put shareholders' interests first. Publicly naming a successor would achieve this fiduciary duty and increase the probability of the company's stock price reverting back towards its intrinsic value.

Disclosure: I am long BRK.B.