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
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.
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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.”