What's Berkshire's Intrinsic Value?

In this post I would like to continue with my takeaways from Warren Buffett's latest annual letter, including my updated intrinsic value estimates.

Right off the bat Buffett comments on the credit debacle:

Some major financial institutions have, however, experienced staggering problems because they engaged in the "weakened lending practices" I described in last year's letter. John Stumpf, CEO of Wells Fargo, aptly dissected the recent behavior of many lenders: "It is interesting that the industry has invented new ways to lose money when the old ways seemed to work just fine."

To this I would say while the techniques may have been new, the underlying driver is the same as always: GREED, fueled by flawed incentive structures. See my post on lollapalooza effects for more on this.

Buffett reiterates his definition of a good business in a section entitled "Businesses - the Great, the Good, and the Gruesome." He uses See's Candies as an example of a great business. It has an enduring competitive moat and has required minimal capital input ($32M since 1972). Yet, it has generated a total of $1.35B of pretax earnings, all of which is shipped off to Berkshire for Buffett to play with. He also lists Microsoft (MSFT) and Google (GOOG) as examples of businesses that require minimal capital input yet generate growing hoards of cash.

He states that businesses which require ongoing capital input can be good businesses, assuming the return on that capital is attractive. Here he uses Flight Safety (Berkshire's pilot training business - Buffett quips that "Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure") as an example of a business with a solid moat but one that requires continuous capital input. It must keep buying very expensive flight simulators to grow. This type of situation is the one faced by most businesses, so it is important to look for good and sustainable returns on invested capital to find the winners.

Buffett uses the airline industry as an example of a "gruesome" business: one that requires tons of capital yet generates no return. As he has stated before, "Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down."

He sums it all up with the following simple analogy:

Think of three types of "savings accounts." The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

Buffett is happy about the performance of Berkshire's equity holdings in 2007. He states:

I should emphasize that we do not measure the progress of our investments by what their market prices do during any given year. Rather, we evaluate their performance by the two methods we apply to the businesses we own. The first test is improvement in earnings, with our making due allowance for industry conditions. The second test, more subjective, is whether their "moats" - a metaphor for the superiorities they possess that make life difficult for their competitors - have widened during the year. All of the "big four" [American Express (AXP), Coca-Cola (KO), Wells Farg & Co. (WFC), Procter & Gamble Co. (PG)] scored positively on that test.

CNBC had its Buffett Q&A session on Monday morning which was great. It was by far the most rational commentary you are likely to ever see on that or any financial network. A couple of interesting comments:

He said that if he knew the bottom for a particular business he still wouldn't have any idea what the bottom for the stock would be. This is another reminder that in the short term, and especially in periods of market turmoil, prices may have little to do with underlying business values.

He also advised that if you worry a lot about the stock market on any given day, you shouldn't buy stocks.

So, what about Berkshire's intrinsic value?

I previously wrote about this topic here and outlined my methods. IV hasn't changed much since then: for the book value method I get $158,000 for A shares ($5267 for B shares), while the float method spits out about $160,000 ($5333 for B shares). Hence, the stock is trading at a modest discount of about 12% to these estimates. I continue to hold it in many of my managed accounts, but will wait for lower prices to add more.

Comments

[clear1]

Great article! We agree with your math on the intrinsic value...we are willing to add shares at a modest 20% discount to that price. If you had to buy-and-hold something for the next ten years...and not sell it until the end...can you think of a better idea. With that $40b+ cash hoard (and more everyday), can you think of a better capital allocator that WB as the market grinds lower? We wrote an article 6 months ago on our website detailing 15 reason to own BRK...they are all still intact. Looking forward to hearing more of your thoughts on BRK and other high quality businesses.

[helplessobserver]

Soar with the vulture, don't be road kill, invest with Buffett as he picks off the tastiest morsels.

[dick black]

With all of wb's talk about saving and investing, I take the position that he dislikes poor people.
Otherwise why not lower via splits the price of his shares.
Who has 160,000 to invest in 1 share of a stock?
Only institutional investors.
Yes, if you got in a lifetime ago you have seen appreciation, but what about this generation's opportunity?

[mkreisel]

Haven't you ever heard of B share?

[jjason]

I will not buy any stock that does not pay a dividend. I like to see a return of investment and a return on investment now, not 5,10, 20 or 30 years from now. I am a retired baby boomer. WB is a successful business man. I give him credit for what he has done. But folks like myself (I'm 65) can't invest 150,000 and wait for capital appreciation. By the way, BKA had been a looser too a few years ago. Take a look at a twenty year chart.

[Dharma]

I have been a twenty year owner. In that time, the stock has gone from 2000 per share, to 130,000 per share. I hope to still be an owner 20 years from now. At the same rate, each share will be $7.8M.
BTW, the B shares will then be 240,000 each, so I guess there will be C shares for the noobs.

Buffett's policy on Dividends is clearly stated. Why pay taxes when he can make more money than you can?