Several articles have appeared in the past attempting to measure Berkshire Hathaway's (BRK.A, BRK.B) intrinsic value using projected cash flows. This article follows a different tack, and is based on a sum of parts view of the enterprise suggested by Warren Buffett in some of his past letters to shareholders. The second part of this analysis takes a closer look at certain insurance and insurance-like liabilities that appear on Berkshire's balance sheet. A determination of intrinsic value is then made after a conservative estimation of those liabilities.
Part I: Valuation of investments and operating businesses
The first part of this analysis attempts to measure Berkshire's intrinsic value by viewing the company as having two disparate parts: An investment entity comprising stocks, bonds and cash equivalents, and an operating entity comprising all of Berkshire's operating businesses.
This two-part view of Berkshire for estimating intrinsic value was suggested by Buffett in some of his past shareholder letters. As on March 31, 2012, the investments per 'A' share totaled $106,300. In addition, Berkshire is estimated to produce about $8,000 in pre-tax earnings per share this year from its operating companies (according to this analysis by T2 Partners LLC), a number that it looks on track to attain.
In the interest of conservative analysis, the following four downward adjustments could be applied to the process of obtaining intrinsic value:
- The first would be to disregard all income from insurance underwriting going forward. The assumption is that underwriting operations manage only to break-even in the long run, reversing a recent trend of nine consecutive years of profits. This scenario is plausible in the event of key insurance executives leaving Berkshire, or pricing becoming very competitive. This assumption would bring down the pre-tax EPS estimate from $8,000 to about $7,400.
- An allowance made for the possibility that the S&P 500 index could revisit its two-year low of 1022, attained in June 2010. As of March 31, Berkshire held about $77 billion in common stocks, around the same time that the S&P 500 index was at 1408. If Berkshire's stock portfolio declined at the same rate as the broader index, the carrying value of the stocks would fall by about $21 billion.
- A deduction of $10 billion made from investments, representing funds set aside towards a permanent insurance collateral of sorts. Much of Berkshire's insurance pricing ability derives from its superior capital strength, and a liquid asset that is both large and enduring would be needed to maintain that ability in the future.
- A deduction of $5 billion made from the roughly $32 billion of fixed maturity securities listed in the assets section of the balance sheet, comprising foreign government bonds, mortgage-backed securities, and some non-investment grade corporate securities, among others. In addition, warrants for Goldman Sachs and GE, exercisable at strike prices of $115 and $22.5 respectively, could be worthless at the time of their expiration in October 2013. Their carrying value of approximately $1 billion must also be deducted.
The per-share intrinsic value thus obtained, following the valuation and asset impairment assumptions listed above, would be $143,075 for a Berkshire 'A' share (assuming a pre-tax earnings multiple of 8, in line with the forward P/E's of large caps such as Walmart and Johnson & Johnson). With 1.65 million such shares outstanding, this equates to an enterprise value of $236 billion.
Part II: Assessment of potentially large and unusual losses
The goal of this section is to arrive at the magnitude of excess insurance losses, i.e. losses above and beyond Berkshire's own estimates. In other words, any possibility of a large, negative deviation from stated insurance liabilities must be carefully considered and treated as an unusual loss (The counterpart of such losses, unusual gains, wherein Berkshire ends up overestimating certain insurance liabilities, are also likely to occur periodically, but are assumed to be zero for the discussion here). The present value of such projected losses must hence be deducted from the preliminary estimate of intrinsic value arrived at in the prior section.
Among Berkshire's insurance businesses, Berkshire Hathaway Reinsurance Group (OTCPK:BHRG) and General Re are the ones that are most exposed to potentially large and unusual losses. Their liabilities are depicted below.
For BHRG, the bulk of its liabilities lies in retroactive policies (identified in blue above), insuring environmental, asbestos and latent injury claims to the tune of about $18.8 billion. For those policies, Berkshire considers it unlikely that that estimate will develop upward by more than 15%. In the interest of conservative analysis, one may allocate a wider margin of 30%, yielding about $6 billion in excess, unanticipated liabilities.
Since these are expected to be paid many years (or in some cases, decades) from now, the present value of that excess liability is less than $3 billion (calculated using a discount rate of 3.3%, the rate that Berkshire used in 2011 to value its equity index derivative positions). The remaining liabilities of BHRG amount to about $7.7 billion, net of ceded reserves. A safety margin of 30% applied to those numbers as well, assuming those policies' remaining term to be about 5 years, yields a liability of $2 billion in present value.
Gen Re's book value of liabilities stands at about $16.3 billion (identified in red above). Again, applying a margin of safety of 30% to that number, assuming an average claim-tail of about 5 years, and adjusting for ceded reserves of about $1 billion, the spill-over of excess liabilities stands at $3 billion in present value. A similar reasoning (30% margin of safety, claim-tail of 10 years) for the $9.9 billion in liabilities identified in the balance sheet as 'Life, annuity, and health insurance benefits' (not depicted), yields a present value of $2 billion in liability overruns.
One additional operational area within Berkshire that can expose it to large, exceptional losses is catastrophe reinsurance. It would be prudent to examine what capital needs would be imposed on Berkshire should a large catastrophe occur in the near future. Buffett's statement in this regard should give a clue on the nature of the exposure Berkshire faces: 'If the insurance industry should experience a $250 billion loss from some mega-catastrophe - a loss about triple anything it has ever faced - Berkshire as a whole would likely record a moderate profit for the year because of its many streams of earnings'. Based on this assertion, one could surmise that a mega-catastrophe would cost Berkshire in the vicinity of $15 billion.
Lastly, of the derivative positions outstanding as on March 31, 2012 (depicted above), only the two highlighted items have a material effect on future earnings (The others are set to expire in 2012 and 2013). The equity index put positions could potentially require about $34 billion in payouts, but that is only a theoretical number that will be realized in the highly unlikely event of the underlying indices going down to zero over the next decade or so.
Even assuming that the ultimate settlement amount could reach as high as $20 billion (a possibility if the stock indices were to remain low, and exchange rates moved unfavorably), the present value of excess liability is about $8.5 billion. A similar conservative analysis of the credit default contracts, assuming they were to eventually cost Berkshire triple of what they accounted for it, would yield a liability of about $1.5 billion discounted to the present.
In this article, several stringent assumptions were made in the process of estimating Berkshire's intrinsic value. The first was that insurance underwriting operations would generate zero profits going forward. A multiple of 8 was then applied was to the pre-tax earnings of operating companies. A decline of more than 25% from the S&P 500 index value on March 31, 2012 was priced in, erasing $21 billion from the carrying value of Berkshire's equity holdings. A further deduction of $10 billion was made from intrinsic value, intended to serve as a permanent collateral needed for Berkshire to maintain premium insurer status. In addition, certain other financial assets totaling $6 billion were also marked for impairment.
In the second part, additional deductions to intrinsic value were made to account for potentially large and unanticipated insurance losses: $10 billion in excess losses arising from (re)insurance retroactive policies sold by BHRG and Gen Re, $15 billion to cover for an imminent mega-catastrophe, and $10 billion in runaway equity and credit derivatives holdings losses above Berkshire's estimates.
In the improbable likelihood of every negative scenario listed above coming to bear at once, the intrinsic value of Berkshire would be about $201 billion, or $121,818 per 'A' share, slightly above its trading price as on 06/05/2012. Based on this estimate, and the abundance of buying opportunities that are afforded to Berkshire by the ongoing market disruptions, it could be inferred that the shares are moderately to significantly undervalued.
Disclosure: I am long BRK.B.