The annual meeting of Berkshire Hathaway Inc. BRK.ABRK.B is one of the most highly anticipated events of the year for value investors. The primary reason is to listen to two of the most successful investors the world has ever seen, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), share their views on the market. Over the last few decades, these two gurus have provided invaluable insights into the economy and investing strategies that have helped millions of investors.
Because of the nation-wide lockdown related to the Covid-19 pandemic, Berkshire was forced to take its meeting online, and Munger did not attend the event on May 2. Many financial media outlets have already written extensively about Buffett’s remarks on the markets being overvalued, but there seems to be confusion among investors as to why the conglomerate reported a massive loss of $49.7 billion for the first quarter of the year. As often is the case when it comes to investing, this loss should not be taken at its face value. A deeper dive is required to understand what this implies.
The accounting rule change every Berkshire investors should know about
In December 2017, the rules on how to report unrealized gains and losses changed as the Financial Accounting Standards Board introduced a new standard known as ASU 2016-01, or Recognition and Measurement of Financial Assets and Financial Liabilities, which was explained as follows:
“Require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.”
The change in reporting requirements resulted in wild swings in net income for companies that invested in equity securities of other publicly listed companies, such as Berkshire Hathaway. The equity method of accounting for a financial asset is usually applied when an investor holds between 20% and 50% ownership of a company. Because the conglomerate usually buys less than 10% of other companies, many analysts concluded in 2017 that Berkshire's future earnings would be highly volatile.
Buffett warned investors two years ago
The guru, in his 2017 letter to shareholders, discussed the new reporting requirements in detail and concluded his remarks by warning investors against using net income as a measure to evaluate the financial performance of the company. Buffett wrote:
“Berkshire owns $170 billion of marketable stocks and the value of these holdings can easily swing by $10 billion or more within a quarterly reporting period. Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance. For analytical purposes, Berkshire’s bottom-line will be useless.”
As investors have now come to realize, his warning was spot on. The earnings of Berkshire are now more volatile than they have ever been.
Does this volatility require a discount to its valuation?
This is a very tricky question to answer, and analysts have been quiet on this subject for the most part as there are two sides to the story. First, analysts will continue to use net income regardless of the accounting rule change. The media will also do the same, which was evident from how Berkshire’s first-quarter loss was interpreted by many outlets. Without a doubt, reporting of this nature will impact the market sentiment toward company shares, which could lead to higher volatility in the share price as well. This suggests that existing valuation models for Berkshire should include a discount to account for this expected volatility in earnings.
The best course of action when determining the fair value of a security, however, is to use a technique that is consistent with the business operations of a company. For instance, it’s standard practice to use dividend discount models to value public utilities, discounted cash flow methods to evaluate non-cyclical sectors such as pharmaceuticals and earnings multiples to analyze growth stocks. Berkshire Hathaway’s fortunes are closely tied to the success of its portfolio companies. Therefore, it would be reasonable to use a price-book approach to determine the intrinsic value of the company, the same way it is used to evaluate other asset-based business sectors such as the financial services industry.
In the long term, Berkshire shares will most likely follow the book value trends rather than earnings. If an investor chooses to use such a technique, a discount to account for volatile net income will not be required.
Whether to apply a discount or not depends on how an analyst or investor is trying to determine the intrinsic value estimate for the company.
The fair value of Berkshire Hathaway shares
Building on the previous point, a justified price-book multiple was calculated using the below assumptions.
- An average return on equity of 9%. According to Morningstar data, the five-year average is 9.95%.
- A growth rate of 2%.
- A required return on equity of 7%.
Based on these inputs, the justified price-book ratio comes to 1.50. In January, the book value per share was $261,409, implying a fair value of $392,113. This represents an upside of 47% from the market price of around $265,861 on May 4.
Takeaway: the reported loss for the first quarter is not a true reflection of Berkshire’s profitability
The focus of many investors is on the massive loss reported by Berkshire Hathaway for the first quarter of the year. However, an understanding of the recent reporting requirement changes is required to correctly interpret this lackluster financial performance. Using a justified book value, shares can be deemed significantly undervalued. According to the latest filings, the company had approximately $137 billion in cash as well, which will be opportunistically deployed by Buffett and his lieutenants to improve the financial performance of the company in the coming years. The guru suggested on Saturday that markets are still overvalued, which is the primary reason the company has such a large cash pile.
The long-term outlook for Berkshire is positive. The company has more than enough cash to bail out any one of its holding companies should the need arise. This could also be the strategic reason it decided to increase its liquidity position recently. Value investors can expect stellar returns from Berkshire shares when business activities return to normal.
Disclosure: I do not own any stocks mentioned in this article.
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