Warren Buffett (Trades, Portfolio)’s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) is a company that splits opinions in the investing community. Most value investors are happy to own shares in the conglomerate, following Warren Buffett (Trades, Portfolio)’s lead. On the other hand, growth investors and some value investors avoid Berkshire Hathaway due to its industrial roots and key man risk.
But while Berkshire stock splits opinions among investors, there is no denying that over the years, Warren Buffett (Trades, Portfolio) has achieved the best returns around for his investors. Since 1965 to December 2015, Berkshire’s shares have returned 20.8% per annum for a cumulative gain of 1,598,284%, compared to an overall gain for the S&P 500 with dividends included of 11,335%. Over the same period, Berkshire’s book value has increased by 19.2% per annum, or 798,981% on a cumulative basis.
It is my view that Berkshire still presents an attractive investment opportunity for value investors today. The company has become a model of capital allocation and efficiency with Buffett at the helm. The insurance business throws off cash to be reinvested in other industries and Buffett only seeks companies for acquisition that can produce steady, high double-digit returns on capital and chuck off even more cash.
Still, the conglomerate and decentralized nature of Berkshire means that the business is difficult to value using traditional valuation methods. Indeed, Berkshire Hathaway B shares are trading at a forward P/E ratio of 19.2, P/TB of 3.3, P/B of 1.4, P/FCF of 21.2, P/S of 1.7 and an EV/EBITDA ratio of 8.3, none of which are particularly attractive metrics. However, a sum-of-the-parts calculation (the best way to value such a business with so many moving parts) gives a much more reliable estimate of Berkshire’s intrinsic value.
Looking at Valuation
Before I look at valuation, I should say that one of the reasons why investing in Berkshire is so attractive is because the company has a ‘Buffett put.'
Warren Buffett (Trades, Portfolio) has declared that he will repurchase Berkshire’s shares if they drop below 1.2x times book, which is $186,601 based on the year-end 2015 book value per share of $155,501. With just over $70 billion in cash at the end of the second quarter, Buffett has plenty of financial firepower to buy Berkshire’s shares hand over fist if they drop below the repurchase limit, which should limit the downside below this key level.
Onto valuation. Value investor Whitney Tilson (Trades, Portfolio) has put together the most comprehensive valuation of Berkshire. Tilson believes that within two years, Berkshire will be generating enough free cash flow every year equal to the $32 billion paid for Precision Castparts (PCP, Financial). Figuring out what to do with this cash could become a problem for Buffett and team, but it is a great problem to have. For the time being, based on first-quarter figures, Tilson estimates the current intrinsic value of Berkshire based on a sum-of-the-parts calculation is $283,000. Factoring in a 6% annual growth of the intrinsic value of the business plus $8000 per share cash build over the next 12 months, gives an intrinsic value in the next year of $308,000 per A share.
Meanwhile, UBS places the value of Berkshire at $402.7 billion or $244,043 per A share and $163 per B share. Of this, UBS estimates the value of Berkshire’s non-insurance companies is $243 billion, and the value of the insurance companies is $159.6 billion. A non-insurance profit margin improvement of 25 basis points and return on equity improvement of 50 basis points, combined with a reduction in Berkshire’s cost of equity from 8.5% to 8%, could increase the company’s valuation to $274,000 per A share. UBS Says Buy Berkshire Hathaway: What You Need To Know
Most analysts appear to agree the Berkshire is undervalued but the company has significant key man risk. Warren Buffett (Trades, Portfolio) isn’t getting any younger, and it is unlikely he will be running Berkshire in ten years time. However, Morningstar believes investors don’t need to be concerned about Berkshire after Buffett. The reason why they think this will be the case is because Buffett has instilled a culture of decentralization and efficient capital allocation within Berkshire. Therefore, even without Buffett in charge, it can be assumed that the group will continue on its current course throwing off cash and making select acquisitions when necessary.
Nonetheless, the one thing Morningstar’s analysts believe will change is the company’s cash return policy. If Tilson’s forecast of $32 billion in free cash flow within two years becomes reality, Berkshire will struggle to reinvest such a large volume of funds efficiently. When Buffett departs, it is likely Berkshire will begin to redistribute a chunk of its annual free cash flow to shareholders.
The Bottom Line
So overall, Berkshire Hathaway is still undervalued according to the analysis from several different views. Over the next few years the company will generate tens of billions of dollars in free cash flow, and while what Warren Buffett (Trades, Portfolio) and his team decide to do with this cash remains to be seen, the cash buffer will give Berkshire an enormous amount of flexibility. Depending on what Buffett decides to do with the cash, Berkshire’s value could be vastly higher from what it is today two years down the line.
When it comes to the question of what happens to Berkshire after Buffett? It is apparent that the decentralized nature of Berkshire Hathaway will ensure that the business continues to operate at its current study pace without Warren Buffett (Trades, Portfolio) overseeing operations. Berkshire Hathaway stock is still an attractive buy for value investors.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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