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The Pleasure of Finding Things Out - Why Book Value and Why 120% Part II

May 25, 2014
Grahamites

Grahamites

112 followers

In my previous article, I wrote about the definition of book value and the 5 components of book value. However, I still haven't answered the question why book value growth is a good proxy for Berkshire Hathaway's intrinsic value growth and why buying Berkshire's share up to 120% makes a lot of sense. I'll try my best to tackle them in this article.

As we recall, shareholder's equity of a public company has 5 components

Common Stock and Paid-in Capital in Excess of Par
Accumulated Other Comprehensive Income
Retained Earnings
Treasury Stock
Non-Controlling Interests

In Berkshire's case, we can use the method of elimination to filter out the components that are of limited use here.

During its history, Berkshire has occasionally issued shares to acquire other businesses but the extent is de mimimum compared to most other publicly traded businesses. So we can disregard Common Stock and Paid-in Capital in Excess of Par for the purpose of this discussion.

Share repurchases is even more rare than issuance of Berkshire's shares. It was not until recent years did Buffett first announce share buybacks up to 120% book value. Therefore, we can also disregard the Treasury Stock component of owner's equity.

Non-Controlling Interest is a tricky one. My inclination is that Non-Controlling Interest is not material either. First of all, by definition, these are minority interests and therefore, considerably smaller than the portion of Berkshire's controlled interests. Furthermore, they are likely to be acquired by Berkshire in the future anyway. When that happens, there usually is some accounting adjustments to the account, which make the minority interests differ substantially from what they were before Berkshire's full ownership. This combination of immateriality and uncertainty makes it seemingly appropriate to exclude Non-Controlling Interests from our discussion.

We are left with Retained Earnings and AOCI. I believe these are the key components of shareholder's equity, or book value of Berkshire.

If we think about Berkshire's business model, which is compounding invested capital and intrinsic value by acquiring ownership or partial ownership in great businesses and keeping them compounding for as long as possible, we will naturally ask the question how we can judge that.

Well, in the case of wholly-owned subsidiaries, the increase in intrinsic value can be measured by their net income, which will be reflected in Berkshire's consolidated net income. Since Berkshire doesn't pay dividend, increase in net income is the same as increase in Retained Earnings, which is a significant component of Berkshire's book value.

In the case of partially owned businesses, the change in unrealized gains and losses from investment, which often has the largest impact on AOCI, is a good proxy for changes in intrinsic value. This account is mainly the yearly appreciation of Berkshire's equity investment holdings such as WFC and KO and Berkshire's other investments such as the warrants in BAC. Therefore, over time, change in unrealized gains and losses is a good proxy for Buffett and Munger's investment skills. We can easily track the year over year change in the Statement of Other Comprehensive Income.

By now, the link between Berkshire's book value and intrinsic value is clear. Berkshire' intrinsic value grows in two ways:

1)increases in net income of wholly-owned subsidiaries, which includes realized gains from investments, and

2) increases in unrealized gains from investments.

The first is reflected in Berkshire's net income, which then flow through Retained Earnings. And the second is reflected in AOCI. Both Retained Earnings and AOCI are substantial components of Berkshire's equity, or book value. Therefore, over the long run, book value growth exactly reflects Berkshire's intrinsic value growth. This is true both on aggregate and on a per share basis.

What about Buffett's 120% book value rule then? What's magic about 120%? Well, Berkshire's book value has been compounding at roughly 20% per year over its history. If we define Berkshire's trailing 12 month book value as a dollar, that dollar will on average appreciate 20% during the next 12 months. So after 12 months, the new dollar's value will be 120% of the old dollar. If during this 12 month period we can buy the new dollar for less than 120% of the value of the old dollar, we are essentially buying the new dollar below its guaranteed face value at the end of the 12 months. In practice, if Berkshire buys back shares at 1 times trailing 12 month book value, the same share will likely to worth at least 120% book value by the end of Berkshire's reporting period. This is the equivalence of buying a dollar for 80 cents. But if Berkshire pays more than 120% of book value for its own shares, Berkshire's book value will have to grow at more than 20% for Berkshire to buy a dollar for less what its guaranteed worth.

(update: looks like I may have missed my boat on the 120% book value rule. I am very well aware of that 1) book value for Berkshire is an understatement of intrinsic value and 2) Berkshire's book value has grown at low double digit rates as opposed to 20% average. If the readers can opion on why 120% despite of the above two factors, I will be greatly grateful)

Now I have found satisfactory answers to my original questions. They may not be the perfect answers but at least my understanding for Berkshire and the concept of book value has definitely improved dramatically over the course of my study. I started my study as a complete ignorant idiot. Fortunately, the process of ignorance removal worked beautifully as I found out more little by little. This is the pleasure of finding things out. It is the same in investing as it is in science. I encourage the readers to try this exercise on their own.

Let me end with one of my favorite quotes from Feynman, which served as the guidance for my article series:

But the game is to try to figure a thing out, with what we know is possible. It requires imagination to think of what’s possible, and then it requires an analysis back, checking to see whether it fits, whether it’s allowed, according to what is known.


Rating: 4.6/5 (10 votes)

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Comments

chaoranhu
Chaoranhu premium member - 2 months ago

I have enjoyed reading your articles a lot. They are always concise and not suffering from over analyzing. But in this series, I like part I much more than part II. I don't find your reasoning of why Buffet using 120% book value as a buyback price entry point as convincing. First, Berkshire book value growth hasn't averaged 20% since the 2000. In fact, its CAGR is only 9.5% during 2000-2013. That's not even close to 20%! Secondly, if it does grow 20% per year on an averaged long-term basis, for a collection of stable businesses (or in fact any) like Berkshire's, it would be worth far more, probably at least 2.5 times or more of book value. In my mind, I think the market would be willing to pay 2 times if the book value grows 15% a year, and perhaps 1.5 for 12% growth. Given the lost nature of the last decade, Buffet might think Berkshire could do better and grow like 12-15% and hence be worth 1.5 - 2 times book value. If that's the case, paying 120% makes sense. That's just my guess.

dpradeep73
Dpradeep73 premium member - 2 months ago

Berkshire's book value lately has been growing by 10% and not 20. So buying at 120% of book would mean Buffett would be two years ahead of his time.

varunfriend
Varunfriend premium member - 2 months ago

If we assume a BV of $100 that is being compounded at 10% then expected after tax earnings should be $10. Applying a 15x multiple gives us a fair value of $150. If the expectation is that that the BV will keep getting compounded at that rate and that the stock price will converge to fair value at some point in the future (say 5 years) then in 5 years:

BV = $161

After tax earnings = $16

At 15x multiple stock price ~ $240 (15x is used because over the long run the stock market yields about 6 - 7%)

So if we bought it at 1.2x current book value then the expected return in 5 years will be ~15%

Ie buying a security that will compound BV at 10% at 1.2x present BV should yield an expected return of 15% over the long term.

graemew
Graemew - 2 months ago

I think that the price of something has to be judged in comparison with the price of other similar assets. If other similar assets with a similar growth rate and risk profile are selling at a higher ratio of book value then that would make Berkshire a worthwhile investment. However it is also necessary to adjust for current market levels and to calculate on the basis of a ''normal'' market level. We are dealing with very subjective valuation...I think the figure of 120% would have to be a very safe, ball-park figure for Buffett. In other words 120% is just a very rough approximation...I don't think there is any reliable way to calculate this figure accurately.At least that's the way I see it.

saharainvesting
Saharainvesting - 2 months ago
This is how I think about it: if you own 100% of any business, you own all of its invested capital. The amount I am willing to pay to get that invested capital from you depends on its annual return. So if I look at your invested capital and determine that I will get 15% every year, either in the form of income or growth of the invested capital, then the value I give that invested capital depends on my required rate of return. If I want a minimum of 10% annual returns (say because I could invest my money in existing ventures that earn that) then I will pay up to 1.5 times the book value of your invested capital. I want 10% every year, so paying 1.5x something growing 15% will give me 10%.

This, I believe, is what it means to value a business using price to book. You are making statements regarding: 1) the rate of return you will get every year and 2) your required rate of return.

This is what Charlie Munger (Trades, Portfolio) means when he says that in the long run, the return you get from a stock is equal to the business’ return on capital (presuming its ability to compound remains unchanged, which is also why he and Buffett look for businesses with moats and plenty of reinvestment opportunities).

Note: I am not necessarily saying these are all the reasons that Berkshire is worth at least 1.2x book to Buffett. I am sure he also thinks book is understated, maybe due to the large DTL, maybe for other reasons.

Grahamites
Grahamites premium member - 2 months ago

Chaoranhu - First of all, thank you for the very nice words and thank you for your genuine opinion. I think your reasoning makes much more sense than my weak thinking in the case of the 120% rule. It was a wild guess from me and now I certainly think I'm not even close to the answer yet.

Grahamites
Grahamites premium member - 2 months ago

Deepradeep73: The recent 9.5% in my opinion is not representative of Buffett' compounding ability. We are in an extraordinary period of time and in this environment, Berkshire is bound to underperform badly.

Grahamites
Grahamites premium member - 2 months ago

Varunfriend:Your analysis makes sense to me. It certainly is consistent with Buffett's 15% rule.

Grahamites
Grahamites premium member - 2 months ago

Graemew: I agree with you that the price of something has to be judged in comparison with the price of other similar assets. If other similar assets with a similar growth rate and risk profile are selling at a higher ratio of book value then that would make Berkshire a worthwhile investment.

I doubt that 120% is Buffett's appoximate figure though. He said repeatedly that he knows Berkshire is worth at least 120% BV but how much above that he doesn't know. My personal opinioni s that there is some rational math behind this number. But again, it's my guess and I have failed in my attempt.

Grahamites
Grahamites premium member - 2 months ago

Saharainvesting- Your statement makes sense in general. I do think you are missing the component of equity leverage though. A business can have fabulous return on capital if it levers up and things go well. I think Munger meant unleveraged return in his statement.

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