Berkshire Hathaway (BRK.A) (BRK.B) is a long position of two good friends: one a smart and successful investor, the other an analyst. They both recently read an interview in Barron's where the fund manager (De Lardemelle) stated that BRK.A's earnings did not fully reflect the earnings of its equity investment in other companies, such as Coca-Cola (KO) (Barron's magazine, August 11, 2012, Ways to Play American Exceptionalism).
Below is the excerpt from Barron's:
Questioner: By our calculations, the stock is trading at around 15 times next year's profit estimate of $8,265 a share.
De Lardemelle: What that is not catching is the earnings on their equity portfolio, including Coca-Cola. If you consider those earnings, the stock trades at closer to 11-12 times. What I also like about Berkshire Hathaway is that if there is a downturn in the equity markets, it usually allows it to grow its intrinsic value faster as they put more money to work. It is very unusual to have a business that grows in value as the economy or the stock market falls sharply.
Below is the dialogue between the investor and the analyst on BRK.A's P/E multiple issues:
Investor: I think the 11-12 is a little aggressive. Also, since dividends received by Berkshire are counted in earnings, there is some double counting going on. Therefore, my best guess is that the true multiple on next year's earnings is 13.
There you have it. 13.
It is possible that I am the only one on the planet who knows the P/E multiple. But can we be sure?
Analyst: Your intuition about the presence of dividend double-counting is correct. Dividends need to be subtracted when using the equity method of accounting (see below). To clarify this issue, let's use Coca-Cola as an example.
BRK.A is currently reporting its equity investment as "Investment in financial assets." Using this method, it reports dividends received from KO and realized gains/losses in its income statement. On its balance sheet, it reports KO's current stock value. (Unrealized gains/losses are also reported, in either the income statement or Other comprehensive incomes, depending on whether it is a held-for-trading or available-for-sale security.)
However, if BRK.A were to use the equity method to report its KO holding, then it would report its % ownership of KO earnings in its income statement. On its balance sheet, it would report initial investment cost + % ownership of KO retained earnings (after dividend payout).
The guideline is that for an investment with <20% ownership, "Investment in financial assets" should be employed. For 20-50%, the equity method is appropriate. Now, can you re-calculate the P/E for BRK.A, using the equity method?
Investor: Your approach is too long.
The multiple is 13.
Stay long. Low Beta. B+ management. A++ on tax efficiency.
Analyst: An analyst is fixated on getting accurate numbers, whereas a smart, intuitive (but impatient) investor just wants ball park estimates that are good enough to guide his/her investment decisions. So what are the earnings and P/E multiples for BRK.A if it would include the percentage of earnings from its equity investments?
(A) 2011 numbers are obtained from BRK.A 2011 10-K.
(B) According to Bloomberg, BRK.A's 2012 and 2013 profit estimates per share are $7,912 and $8,265. From these per-share earnings estimates, we derive estimated total earnings of $19,363 and $20,194 for 2012 and 2013, respectively.
(C) The equity investment interest and dividend in 2011 was $1,618 (see revenue, finance and financial products, p.66). This includes interest and dividend payments from BRK.A's investment in banks, insurance companies, consumer products, commercial, and industrial companies (p.78). This number does not include the preferred dividends from its investments in Goldman Sachs (GS), GE, Wigley, Dow, and Bank of America (BAC). The preferred dividends are shown as Other Investments (p.79, p66).
(D) We assume that the interest and dividend income will grow 5% annually. This assumption results in the interest and dividend income of $1,700 and $1,784 estimates for 2012 and 2013, respectively.
(E) If BRK.A were to use the equity method to account for its ownership in those equity portfolio companies, then it would report % earnings instead of dividends. Assuming these companies have a 40% dividend payout ratio, BRK's earnings from the equity investments would be $4460.
To summarize: BRK.A's 2013 P/E is 15.39x based on the current accounting method. However, if BRK.A were to use the equity method to account for its equity portfolio investment, the P/E would be 12.45x. Given some margin of safety, the Investor's estimate of a P/E of 13 is quite reasonable.
Table 1: Calculation of BRK.A P/E multiples
Financial assets method
Interest, Dividend, other investment
Earnings before tax
Net earnings to BRK
Earnings from equity method investment
Net earnings (total)
Stock price (as of 8/10/2012)
Disclosure: I am long BRK.B.