"BERKSHIRE HATHAWAY INC. INTRINSIC VALUE – TODAY AND TOMORROW
Though Berkshire’s intrinsic value cannot be precisely calculated, two of its three key pillars can be measured. Charlie and I rely heavily on these measurements when we make our own estimates of Berkshire’s value.
The first component of value is our investments: stocks, bonds and cash equivalents. At year end these totaled $158 billion at market value.
Insurance float – money we temporarily hold in our insurance operations that does not belong to us – funds $66 billion of our investments. This float is “free” as long as insurance underwriting breaks even, meaning that the premiums we receive equal the losses and expenses we incur. Of course, underwriting results are volatile, swinging erratically between profits and losses. Over our entire history, though, we’ve been significantly profitable, and I also expect us to average breakeven results or better in the future. If we do that, all of our investments – those funded both by float and by retained earnings – can be viewed as an element of value for Berkshire shareholders.
Berkshire’s second component of value is earnings that come from sources other than investments and insurance underwriting. These earnings are delivered by our 68 non-insurance businesses, itemized on page 106. In Berkshire’s early years, we focused on the investment side. During the past two decades, however, we’ve increasingly emphasized the development of earnings from non-insurance businesses, a practice that will continue.
The following tables illustrate this shift. In the first table, we present per-share investments at decade intervals beginning in 1970, three years after we entered the insurance business. We exclude those investments applicable to minority interests.
|Year end||Per-Share Investments||Period||Compounded Annual Increase in Per-Share Investments|
Though our compounded annual increase in per-share investments was a healthy 19.9% over the 40-year period, our rate of increase has slowed sharply as we have focused on using funds to buy operating businesses.
The payoff from this shift is shown in the following table, which illustrates how earnings of our non-insurance businesses have increased, again on a per-share basis and after applicable minority interests.
|Year end||Per-Share Investments||Period||Compounded Annual Increase in Per-Share Pre-Tax Earnings|
For the 40 years, our compounded annual gain in pre-tax, non-insurance earnings per share is 21.0%. During the same period, Berkshire’s stock price increased at a rate of 22.1% annually. Over time, you can expect our stock price to move in rough tandem with Berkshire’s investments and earnings. Market price and intrinsic value often follow very different paths – sometimes for extended periods – but eventually they meet.
There is a third, more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some businesses will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.
This “what-will-they-do-with-the-money” factor must always be evaluated along with the “what-do-we-have-now” calculation in order for us, or anybody, to arrive at a sensible estimate of a business’s intrinsic value. That is because an outside investor stands by helplessly as management reinvests his share of the business’s earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the business’s current value; if the CEO’s talents or motives are suspect, today’s value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck’s or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton." (Reproduced from Berkshire Hathaway Inc. 2010 Annual Report.)
“Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover--and this would apply even to Charlie and me--will almost inevitably come up with at least slightly different intrinsic value figures.” Warren Buffett
OK. So how does Warren Buffett’s “Two-Column Valuation Method” work?
EXAMPLE 1: I will explain, and the answer is simpler than you may think. First, determine the “per-share investments” amount for the most recent year. In Buffett’s 2010 Annual Report, let’s use $94,730. Next, determine the “per-share pre-tax earnings” for the most recent year. In Buffett’s Annual Report, let’s use $5,926.04. Next, determine which multiple to apply to the “per-share pre-tax earnings.” Choose a multiple to apply this other similar businesses show within the same sector/ industry.
Pre-tax earnings can also be referred to as operating earnings, which are found on the income statement. Pre-tax earnings are also referred to as EBIT, or earnings before interest and taxes.
If other businesses stock prices are currently trading at a multiple of pre-tax earnings of 10; then, for this example let’s use 10 as our multiple we’ll apply to pre-tax earnings.
Therefore, if pre-tax earnings are $5,926.04, and we multiply this amount by our multiple of 10, then this equals $59,260.40.
$5,926.04 x 10 = $59,260.40
Next, we add the business’s per-share investments to this amount. Therefore,
$94,730 + $59,260.40 = $153,990.40
EXAMPLE 2: Similarly, if we were to apply a different multiple to Berkshire Hathaway’s 2010 pre-tax earnings of $5,926.04, we would arrive at a different estimated intrinsic value. For instance, if we were to use a multiple of 12 (instead of 10), then…
$5,926.04 x 12 = $71,112.48
Next, if we were to add the Berkshire’s 2010 per-share investments of $94,730 to $71,112.48, Berkshire Hathaway’s estimated intrinsic value at the end of 2010 would be $165,842.48.
$94,730 + $71,112.48 = $165,842.48
Therefore, using Warren Buffett’s “Two-Column Valuation Method,” the intrinsic value of Berkshire Hathaway at the end of 2010 could be estimated to be somewhere between $153,990.40 and $165,842.48. Comparatively, Berkshire Hathaway’s stock price on December 31, 2010 closed at $120,450, well below it is underlying intrinsic value.
“Market price and intrinsic value often follow very different paths – sometimes for extended periods – but eventually they meet.” Warren Buffett
“Wall Street is more concerned with correlation than valuation.” Scott Thompson
“It’s better to be approximately right, than precisely wrong.” Warren Buffett
Obviously, the key to mastering Buffett’s “Two-Column Valuation Method” is correctly calculating per-share investments, selecting an appropriate multiple to apply to pre-tax earnings, and accurately combining these two amounts together to arrive at an estimated intrinsic value.
On one occasion when I met Warren Buffett, I mentioned that John Burr Williams’ valuation method of using discounted cash flows (DCF) of free cash flows (FCF) to calculate intrinsic value worked well for some business valuations, but not for others. We also discussed Graham’s net-net working capital (NNWC) method, and Buffett’s newer two-column method.
I find Warren to be very genuine and down-to-earth. He has not changed despite his success. During our interaction, we were joking, laughing, and just enjoying the conversation. We discussed many topics, including his past valuation methods such as his part net-net working capital method, DCF method, four filters investment process, and his current ““Two-Column Valuation Method.” I find him to be brilliant, and yet having a warm, welcoming personality with a great sense of humor.
Warren and Charlie have developed a simple yet powerful “four filters investment process.” Therefore, Buffett’s “Two-Column Valuation Method” relates to filter no. four (price/value) of their powerful “four filters investment process.” It’s important for you to understand all four investment filters of Buffett & Munger and not just “filter no. four” relating to the quantitative valuation.
Buffett’s decision to publish his “Two-Column Valuation Method” publicly in his Berkshire Hathaway annual report has gone relatively unnoticed. Value investors can benefit enormously by studying the method. I’m glad to be one of the few authors to explain it.
Scott Thompson, MBA, is founder and Managing Director of Intrinsic Value Capital Management, and author of “ART & SCIENCE OF VALUE INVESTING: Invest Like Billionaire Warren Buffett” available at: http://www.lulu.com/spotlight/valuestore and www.Amazon.com in either paper or Kindle versions. Scott can be reached at: [email protected]
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About the author:
Scott graduated from Northern Illinois University (B.S. 1991). At Aspen University (MBA) he graduated "summa cum laude" and earned the "Graduate Student of the Year” award. After college, he worked with several Fortune-500 companies including Merrill Lynch/Bank of America and served as Vice President of an investment bank.
Scott is a philanthropist & has donated thousands of dollars & volunteer hours. Scott serves on numerous boards & charity organizations, including the 5th largest rehabilitation healthcare organization in the USA! Scott Thompson, MBA, is author of best-selling book: ART & SCIENCE OF VALUE INVESTING (foreword by Peter Buffett, son of billionaire value investor Warren Buffett). Contact: www.ProValueSource.com