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Ravi Nagarajan
Articles 

Buffett’s Annual Letter Offers Insight on the ‘Three Pillars’ of Berkshire’s Intrinsic Value

February 27, 2011 | About:
Note to Readers: In this article, we briefly discuss selected aspects of Berkshire Hathaway’s 2010 results based on today’s release of Berkshire’s 2010 annual report (pdf). Earlier today, we discussed the highlights of Warren Buffett’s annual letter to shareholders. Next week, we will publish The Rational Walk’s comprehensive report on Berkshire Hathaway, In Search of the Buffett Premium, which is currently available for pre-order.

Warren Buffett and Charlie Munger have made it a habit to never directly state their estimates of Berkshire Hathaway’s intrinsic value. Due to the fact that intrinsic value estimates are heavily dependent on assumptions made regarding the future, even Mr. Buffett and Mr. Munger come up with somewhat different estimates of Berkshire’s intrinsic value. However, Mr. Buffett has often provided shareholders with the criteria he uses to arrive at intrinsic value estimates. At times, he has either strongly implied or directly commented on his views regarding Berkshire’s stock price versus intrinsic value. In this article, we will take a brief look at additional details Mr. Buffett provided in his 2010 annual letter to shareholders regarding how shareholders should go about calculating intrinsic value. Two Column Approach

In previous annual reports, Warren Buffett has often commented about Berkshire Hathaway’s two sources of value: Investments per share and the capitalized value of earnings per share of the non-insurance businesses. This approach has been described as the “two column” method for calculating Berkshire’s intrinsic value. Essentially, Berkshire is being viewed as having one area of value in the form of investments funded by shareholders’ equity and insurance float and another source of value represented by non-insurance operating companies.

Mr. Buffett describes Berkshire’s $158 billion of investments in stocks, bonds, and cash equivalents and notes that $66 billion is funded by insurance float. Float represents funds held by Berkshire’s insurance subsidiaries that is carried as a liability on the balance sheet. However, as long as Berkshire’s float can be obtained through insurance activities that run at a break-even level or, better yet, at an underwriting profit, float has the utility of equity for Berkshire shareholders in the sense that the investment income emanating from these funds belong to the shareholders.

Viewed in this manner, Berkshire had $94,730 per A share of investments as of December 31, 2010. Overall per-share pre-tax earnings of the non-insurance operating companies was $5,926 for 2010. Mr. Buffett notes that investments per share and earnings can be calculated in a precise manner, but these only form two of the three pillars of intrinsic value. The third is more subjective and is the source of differences in intrinsic value estimates even among those who buy into the “two column” method.

The Third Pillar: Deployment of Future Retained Earnings

Berkshire Hathaway has never paid a dividend or repurchased stock and, as a result, all earnings have been reinvested in various businesses. In most cases where managements hoard cash, poor returns can result if funds are deployed in suboptimal ways either due to the tendency of managers to want to build empires or the fact that most businesses tend to reinvest in the same lines of business where the earnings were generated to begin with irrespective of the availability of acceptable incremental returns on capital.

Mr. Buffett notes that some companies can “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 company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company’s earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’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.

A shareholder’s individual view of how earnings will be redeployed dramatically impacts the manner in which a company’s existing earnings stream should be evaluated. In the case of Berkshire Hathaway, we know the value of investments per share and we have last year’s figure for pre-tax earnings but what capitalization is appropriate to assign to this earnings stream?

The answer depends on the degree to which earnings are paid out to shareholders, in which case shareholders can estimate the cash flows they will personally receive from the company. In the case of Berkshire, however, 100 percent of earnings are reinvested. The power of Berkshire’s business model, other than the fact that Mr. Buffett is the capital allocator, is that businesses that generate significant cash (such as See’s Candies or Business Wire) but lack reinvestment opportunities can have their cash flows directed to more attractive opportunities.

While there are no easy answers regarding how to evaluate the stream of future earnings that Berkshire will reinvest, some estimates can be made based on management’s track record and views regarding future prospects for internal reinvestment and acquisitions. This is one of the valuation models that will be discussed in our upcoming report: In Search of the Buffett Premium.

Bullish on the Long Term Economic Outlook

Mr. Buffett’s letter returned to some old themes such as Berkshire’s history with GEICO, the economics of the insurance business, and an expansion on the discussion of freight rail due to Berkshire’s acquisition of Burlington Northern Santa Fe last year. The letter also reiterated Mr. Buffett’s bullish long term outlook for the United States economy and noted that much of Berkshire’s capital investment has flowed toward opportunities in America over the past two years. All of Berkshire’s increase in capital investment in 2011 will be directed toward opportunities in the United States.

Berkshire’s Unusual Insurance Business

Berkshire’s insurance companies have now operated at an underwriting profit for eight consecutive years after several years of large underwriting losses following Berkshire’s 1998 acquisition of General Re. Mr. Buffett emphasizes how unusual Berkshire’s insurance operations are by highlighting the fact that Berkshire has posted $17 billion in underwriting profits over the past eight years while State Farm, a well run insurer, has incurred underwriting losses in seven of the past ten years and posted aggregate underwriting losses of $20 billion over that period. This long run record bolsters Mr. Buffett’s view that Berkshire should enjoy cost free float over the long run.

Record Earnings at Four Subsidiaries

Four of Berkshire’s businesses in the manufacturing, service, and retail group set record earnings in 2010: TTI, Forest River, CTB, and H. H. Brown shoes. Additionally, Mr. Buffett believes that NetJets is now “fixed” due to David Sokol’s management. NetJets is a topic that we will cover in great detail in our upcoming report.

Todd Combs

Mr. Buffett commented briefly regarding Todd Combs who was hired in 2010 to run $1 to $3 billion of Berkshire’s vast securities portfolio. While Mr. Buffett will continue to manage the majority of Berkshire’s investments as long as he is CEO, he anticipates hiring “one or two” more managers if he can find the right individuals. Mr. Buffett is looking for investors who can anticipate the effects of economic scenarios not previously observed rather than simply showing good past track records.

The Rational Walk will publish selected thoughts on Berkshire’s Q4 and full year 2010 results later today. Next week, we will publish The Rational Walk’s comprehensive report on Berkshire Hathaway, In Search of the Buffett Premium, which is currently available for pre-order.

Disclosure: Long Berkshire Hathaway

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About the author:

Ravi Nagarajan
Charlie Tian, Ph.D., is the founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 3.9/5 (15 votes)

Comments

Kevin Graham
Kevin Graham - 8 years ago    Report SPAM
Ravi,

Great article. The only thing I would tweak is that "float" does not have the same utility as equity. Float is much more like debt than equity. The great thing about Berkshire's "float" aka debt is that the terms are very favorable; low or no interest, non-callable, and the term is infinite.

Now if I left my comment at that, I would probably get one star from some idiot on this site who doesn't understand business or investing. So I will quote Warren Buffett from his "owner's manual", (point number 7) to to make my point clear.

Better yet, this funding (float & deferred taxes) to date has been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting -which we have done, on the average, during our 32 years in the business - the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt - an ability to have more assets working for us - but saddle us with none of its drawbacks.Keep up the good work.

Kevin

rnagarajan
Rnagarajan - 8 years ago    Report SPAM
Agreed - float is a liability, not equity. However, Buffett's point, made year after year, is that as long as float holds constant or grows and comes at low or no cost (or best of all, negative cost), it has the same utility as equity in terms of being available for shareholders to generate investment returns. That's the secret sauce of Berkshire in my opinion, and it drives a good portion of the company's intrinsic value.
tbare06
Tbare06 - 8 years ago    Report SPAM


Both great points.

I think one could argue that float has a negative "real" cost as long as BRK maintains an underwriting profit.

I love the annual report. I am always just fascinated how Buffett describes economics and finance into such simple terms. Andrew Ross Sorkin wrote in "To Big To Fail" that Buffett is perhaps the most articulate writer today when it comes to business and finance. I would have to agree.
grandpagates
Grandpagates - 8 years ago    Report SPAM


After reading the annual report, my opinion is that BRKA has an "effective "PE of 15.

I get this from taking the normal earning power of $12 billion (pg 5), add in $2 billion of look thru (undistributed) earnings (pg 17), divide by 1.6 million shares (pg 33), giving earnings of $8650 / share. and used it to divide into the share price. Todays price is $128050/share, yielding a PE of 15.

If have no idea what the intrinsic value is, but I defer on this to the excellent article (The Myth of Intrinsic Vaue):

http://www.gurufocus.com/forum/read.php?2,120174,page=1

which quotes WEB as saying

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”

BRK is not easy to understand, but having WEB give the normal earning power makes it easy. A PE of 15 is pseudo rational, give that p/b is 1.3, and many items on the books are carried at too low of a value.

Will earnings go up? Will capital be deployed well (a pillar)? No one knows for sure. WEB has consistently advised to look at the rate of change of book value, which as averaged 10% for the last 5 and 10 year periods (pg 4), which implies that earnings will go up at a rate of 10% for awhile.

My opinion is that it would be hard for anyone to mess up the rise in earnings.

In summary, I am holding onto my shares and aspire to buy more.

grandpagates
Grandpagates - 8 years ago    Report SPAM
I am revising my calculations and saying that BRKA has a PE of 11.3

Bloomberg is saying WEB has $28 B of cash on hand

http://www.bloomberg.com/news/2011-07-08/berkshire-spends-4-billion-on-equities-as-combs-adds-stocks-buffett-says.html

which comes to $17,500K per share share, and the share price has dropped to $115K/share. Using the normal earnings power discussed above, that is a PE of 11.3.

Note that Munger said in early July (see gurufocus articles) that those holding BRK today will do well in the future, based apparently on his earlier statement that Berkshire owns many good businesses (e.g. will grow slowly far into the feature).

A PE of 11.3 for a collection of businesses picked to grow by WEB?

It seems that the market has not comprehended Berkshires "grow far into the future" statement.

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