Berkshire Hathaway Appears Undervalued

Includes: BRK.A, BRK.B
by: Philip Frank

Berkshire Hathaway (NYSE:BRK.B) is a core holding in our firm Insight Asset Management’s client portfolios. BRKB has the same claim on Berkshire Hathaway’s assets as does Berkshire Hathaway Class A stock (NYSE:BRK.A), but is worth 1/30th of BRKA, which makes BRKB more affordable.

BRKA recently sold for $140,000 per share. The stock may be under some pressure after its recent earnings release, showing a quarterly earnings decline. Those who use PE ratios to value stocks may also focus on the stock selling for 16X trailing earnings, with the prospect of a tougher insurance climate in 2008. However, PE ratios are the least sophisticated way to value stocks, and I believe BRKA would be conservatively valued at $152,000 per share.

If the economy should surprise on the upside, a case could easily be made for a BRKA price of $180,000 per share. Further, BRKA with its $38 billion in cash and strong balance sheet, is well positioned to make opportunistic deals. In the years to come I believe activist hedge funds may well push for spin-offs and the like which will further realize Berkshire Hathaway’s (Berkshire) value.

What follows is a very conservative analysis which supports the view that BRKA’s stock price is certainly not overvalued, and that BRKB and BRKA are excellent holdings in today’s turbulent market. I utilized four valuation methods in valuing Berkshire Hathaway: a discounted cash flow analysis, price/book, look through earnings, and a sum of the parts analysis.

First, I conducted a 30 year discounted cash flow analysis [DCF] by adding taxed earnings, look through earnings (tax effected), and depreciation, and subtracting capital expenditure, and acquisition expense (projected by using historical acquisition expense as a percentage of revenues). I assumed 5% in annual growth in revenues, 10% operating margins declining to 8% operating margins in later years, 3% growth in perpetuity, and an 8% discount factor. I also assumed growth in look through earnings will slow from 10% to 8% over the years.

Working capital is not easy to forecast, and a case can be made for either positive or negative working capital needs, so working capital needs were not incorporated in the DCF. As a check I calculated on a revenue basis what Berkshire’s share of GDP would be under my model in year 30, as compared to share of GDP presently. The fact that GDP share would be roughly comparable in year 30 suggests I am not being overly-aggressive in my revenue growth assumptions. The discount factor of of 8% is based upon CAPM which includes a risk premium of 4.5% , a riskless rate of 4% ( a little higher than the current ten-year treasury interest rate, to be conservative) , and a beta of 1.

I assumed Berkshire will have the same beta as the S&P over the long-term. This is actually a conservative discount rate as one could argue that Berkshire’s cost of capital is substantially lower. I have treated acquisitions as an expense even though this item does not flow through the income statement. Growth through acquisition has been a major component of Berkshire’s strategy over recent years as it has transformed itself into a conglomerate. And acquisitions, whether by way of cash or by the issuance of stock represent an expense (cash) or a cost (stock issuance) to the Company even though this expense or cost does not run through the income statement. The DCF suggests a conservative valuation of $141,000 to $150,000 per share for BRKA.

Since Berkshire is conservatively capitalized and relatively unleveraged, its ROE is lower than that of a more leveraged entity. I believe that some investors make the mistake of seeing this lower ROE as making Berkshire less valuable than an entity with a higher ROE. Rather, I see Berkshire’s lower ROE as indicative of a less leveraged balance sheet, and thus of a company which will hold up better in a market correction, as it has proven in 2007. In addition, stated accounting ROE actually underestimates economic ROE, as stated ROE excludes look through earnings.

In general, I believe Wall Street does not fully grasp Berkshire as an entity. It is vastly transformed from what it was several years ago when it was largely an insurance operation with a portfolio of common stocks. Over recent years Mr. Buffett has transformed Berkshire into what we it is now as part conglomerate (with additions ranging from the Israeli company Iscar Metalworking to MidAmerican Energy Holdings to Shaw Industries to Clayton Homes), part hedge fund (which has included a significant bet against the dollar, and in the past a large bet on bonds), and part a portfolio of common stocks.

The stock was recently trading at 1.80X book value, a 1/3 discount to the S&P 500 average of 2.7X (at 12/31/2007). I see Berkshire’s non-insurance parts as being worth at least the 2.7X book of the typical S&P company. Given Berkshire’s diverse interests, I believe that the S&P 500 average book value is a better comparison for the stock than are other insurance companies whose sole business is insurance. Incidentally, if we add back to book value ½ the liability of deferred taxes and the full value of unearned premiums, Berkshire is trading at 1.6X book value.

Since Berkshire’s non-insurance earnings before tax [EBT] and minority interest constitute about 45% of total EBT and minority interest, it could be argued that Berkshire’s proper price to book should be a blended rate of 45% of the S&P 500 average book value, and 55% of the average book value of 1.08 of various insurance companies (which has been depressed by the travails of AIG and the problem of writeoffs). This is about where BRKA recently traded, at $140,000 per share.

Let us now look at Berkshire on a look-through earnings basis. Look through earnings are earnings of companies in which Berkshire holds minority investments, in proportion to shares owned, treated as if they are Berkshire’s own earnings. Dividend income is subtracted to avoid double counting. In essence look through earnings account for minority investments as if they met the criteria for utilizing the equity method of accounting. I estimate BRKA is now trading for 13X trailing look through earnings. If we use a conservative 15X 2007 earnings multiple to value Berkshire, a fair price per share for BRKA is $156,000.

Let us now look at Berkshire on a sum of the parts basis. First, the current value of Berkshire’s cash and investments minus all liabilities (excluding unearned premiums and ½ of deferred taxes) is computed. This amounts to $4,900 per share.

Next I value the current insurance business by placing a 10X multiple on EBT. This amounts to $52,500 per share. Next I value Berkshire’s float by utilizing a ten-year DCF, growth in float year per year of 5%, conservative margins of 10% on float, and growth in perpetuity of 3%. This DCF indicates that Berkshire’s float should be valued at $49,000 per share.

I next value the non-insurance business, assuming a 10X multiple of 2007 trailing earnings before tax. This amounts to $43,500 per share. Next we determine the value of Berkshire’s after-tax investment gains exclusive of its equity holdings. This would include such things as its previous bets against the dollar and bets on bonds. These investment gains have averaged $2,750 per share over the last five years. If we put a 10X multiple on this number, we come to a value of $18,000 per share. This sum of the parts analysis suggests a fair price for BRKA of $168,000 per share.

Overall then, whether we use a price/book value approach, look through earnings, a discounted cash flow analysis or a sum of the parts analysis, Berkshire appears undervalued. The average of all the valuations conducted provides the best estimate of BRKA’s value. This average estimate is about $152,000 per A share, some $12,000 per share more than its recent value of $140,000.

Concern has often been expressed that no successor could duplicate Buffett’s prowess. Insight has shared similar concerns. However, the valuation work above assumes almost no Buffett premium. Even in the sum of the parts analysis, if the investment gain portion of $18,000 is subtracted, BRKA would still be worth $150,000 per share in the sum of the parts analysis. The Buffett model of acquisitions in which talented managers are left to run their businesses as they see fit, puts Berkshire on very solid footing even after Buffett is no longer at the helm.

Further, I view Buffett’s donation of Berkshire stock to the Gates Foundation as a long-term positive for the stock. As the Gates Foundation sells its Berkshire stock, activist hedge funds may well be buyers and push for a break up of Berkshire, which as the sum of the parts analysis shows is undervalued. Further, stand alone entities such as MidAmerican and Geico would quite possibly fetch even higher valuations than are implicit in my modeling. The future activity of activist hedge funds could eliminate Berkshire’s holding company discount, in my view.

In addition, Berkshire’s strong balance sheet, with some $38 billion in cash, provides outstanding opportunities in these turbulent stock market times. Berkshire’s deal with Swiss Re (OTC:SWCEY), its deal with the Pritzkers for Marmon, its creation of a new bond insurer, are but a few examples of Berkshire’s saavy. Whereas many companies are value destroyers with ill timed stock buybacks and poor acquisitions, Berkshire has shown itself to be a master allocator of capital in which building shareholder value is paramount.

Related: Berkshire Hathaway Annual Shareholder Letter - Online Version

Disclosure: Author's clients are long Berkshire Hathaway