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Dilantha De Silva
Dilantha De Silva
Articles (183)  | Author's Website |

Book Value Is No Longer a Good Measure of Berkshire's Value

Investors need to choose a model that better reflects the reality

Book value was once one of the most-used valuation techniques to determine the intrinsic value of companies via a value investing strategy, including Berkshire Hathaway, Inc. (NYSE:BRK.A) (NYSE:BRK.B). For a long time, both investors and analysts have used this number to gauge a measure of whether investments could be undervalued in the market.

This is particularly true for Berkshire. If we go back to check the roots, it's evident that Warren Buffett (Trades, Portfolio) had a significant role to play in this trend. In the 2011 annual shareholder letter, the guru opened up about valuing Berkshire Hathaway and wrote:

"We have no way to pinpoint intrinsic value. But we do have a useful, though considerably understated, proxy for it: per-share book value. This yardstick is meaningless at most companies. At Berkshire, however, book value roughly tracks business values. That's because the amount by which Berkshire's intrinsic value exceeds book value does not swing wildly from year to year, though it increases in most years. Over time, the divergence will likely become ever more substantial in absolute terms, remaining reasonably steady, however, on a percentage basis as both the numerator and denominator of the business-value/book-value equation increase."

Investing in the market, however, requires a lot of time dedicated to keeping track of new developments at both the macroeconomic level and the company level. More than eight years have passed since Buffett wrote this invaluable piece, and Berkshire is no longer the company it used to be in 2011 as well. This, combined with the recent remarks by Buffett, suggest book value is no longer an accurate representation of the reality that the company faces.

The guru's more recent remarks

Many market participants are aware of Buffett's remarks highlighted earlier, but not as many tuned in to how he walked back on his 2011 suggestions in 2019. The below is an excerpt from the 2018 Berkshire Hathaway annual shareholder letter sent to investors on Feb. 23, 2019:

"Longtime readers of our annual reports will have spotted the different way in which I opened this letter. For almost three decades, the initial paragraph featured the percentage change in Berkshire's per-share book value. It's now time to abandon that practice.

The fact is that the annual change in Berkshire's book value — which makes its farewell appearance on page 2 — is a metric that has lost the relevance it once had. Three circumstances have made that so. First, Berkshire has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses. Charlie and I expect that reshaping to continue in an irregular manner. Second, while our equity holdings are valued at market prices, accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years. Third, it is likely that — over time — Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value. The math of such purchases is simple: Each transaction makes the per-share intrinsic value go up, while the per-share book value goes down. That combination causes the book-value scorecard to become increasingly out of touch with economic reality."

The guru couldn't have been clearer on his thinking as to why per-share book value is no longer a reliable estimate of Berkshire's intrinsic value. That being said, many investors continue to focus on this figure because of what Buffett wrote earlier in 2011, which seems inaccurate and counterproductive to me given the analysis that the company's number one insider has provided.

An alternative valuation technique

A sum of the parts valuation seems to me to be the best way forward to determine Berkshire's value. To correctly use this mechanism, an investor has to take an ownership perspective and find the value of Berkshire's holding companies.

To do this, an investor can choose an appropriate technique according to the company being valued. For instance, the conglomerate's stake in Bank of America Corporation (NYSE:BAC) can be evaluated using an asset-based approach, whereas a company like Apple, Inc. (NASDAQ:AAPL) may need to be valued using a discounted cash flow approach.

Once both the intrinsic values of Berkshire's percentage ownerships in its investments and the full values of its constituent companies (such as the insurance business, BNSF, etc.) are calculated, the investor can derive a proportionate value that should be reflected in Berkshire's books. The final step is to sum up all these values to find Berkshire's total worth.

Morningstar uses a similar approach to find the true value of Berkshire. In a report highlighting his approach, Morningstar analyst Greggory Warren wrote:

"We rely on a sum-of-the-parts methodology that values the different businesses separately and then combines these values to arrive at a total value for Berkshire Hathaway. As part of this process, we use discounted cash flow methodologies to value each of the company's major segments: the insurance operations (including the investment portfolio attached to this business), BNSF, Berkshire Hathaway Energy, and the manufacturing, service, and retail operations."

The below is an illustration of the value calculated by the analyst for the two classes of Berkshire shares:

Source: Morningstar

Even though book value has been a reliable indicator of the company's value in the past, things might not be the same anymore. Because of this reason, investors need to look for complicated valuation techniques to find the true worth of Berkshire shares to be successful in identifying potential investment opportunities.

The stock seems to be undervalued heading into 2021

Berkshire Hathaway made it into Barron's top 10 stock picks for 2021, a list that many investors keenly follow to find attractive investment opportunities. The company's unique position makes it both a defensive play and a bet on the recovery of the global economy.

For instance, Berkshire has a massive stake in Apple, which is bound to perform better if consumer spending grows as expected in 2021. On the other hand, the billion-dollar stakes in businesses such as The Kraft Heinz Company (NASDAQ:KHC) make Berkshire a defensive play that could weather a severe economic downturn. This is one of the characteristics loved by Barron's as well.

The stock buyback program is another value driver for shareholders. During the third quarter, Berkshire bought back a record $9 billion of its stock, and this will help the company report better per-share earnings figures in the coming years. Also, buybacks are a source of income and long-term investors will reap the rewards of billion-dollar stock repurchases. On top of this, Buffett's decision to buy back Berkshire shares implies his belief that the stock is significantly undervalued.

Value stocks, in general, seem to be undervalued as growth strategies continue to outperform, and an eventual comeback from value will set a strong platform for Berkshire to deliver stellar returns to investors in the long run.

Takeaway

Berkshire Hathaway, one of the most-followed companies in the world, seems to be undervalued as we head into a new year.

Even though growth-oriented investors might want to wait for a better opportunity given the company's lackluster growth expectations in comparison to many red-hot names, value investors should be thrilled by what they see.

Buffett is sending a clear signal to the market by buying back billions of dollars in Berkshire's stock, prominent Wall Street analysts believe the stock is a bargain at the current price level and there is an expectation for value investment strategies to come back strongly in the future. With over $140 billion in cash, the company is well-positioned to double down on any good investment opportunities that may come along as well. Considering all these positive developments, I find it hard to argue with the conclusion that Berkshire is a good value investment.

Disclosure: The author owns shares in The Kraft Heinz Company.

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About the author:

Dilantha De Silva
I am an investment professional with 5-years of experience in financial markets. I specialize in U.S. equities and incorporate a top-down approach to identify developing macro-level trends and the companies that would benefit from such trends. I am a strong believer that the best investment opportunities could be found in under-covered equities.

I currently work with leading financial publications including Refinitiv, Seeking Alpha, ValueWalk, GuruFocus, and TradeGrill to produce investment-related content.

I\\\'m a CFA level 3 candidate and an Associate Member of the Chartered Institute for Securities and Investment (CISI, UK). I am a registered candidate for the Chartered Wealth Manager program as well. During my free time, I enjoy reading.

Visit Dilantha De Silva's Website


Rating: 4.5/5 (2 votes)

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Comments

Praveen Chawla
Praveen Chawla premium member - 3 months ago

Nice article Dilantha. Actually the value cited by Morningstar is not too far off that obtained by median PB which I cited in my article Berkshire Is Still One of the Best Values in the Market - GuruFocus.com

Dilantha De Silva
Dilantha De Silva - 3 months ago    Report SPAM

Thanks. I will check your article as well. I think I missed it. Morningstar, by the way, does a wonderful job in covering a lot of companies in depth.

dirt2624
Dirt2624 premium member - 3 months ago

Buffett still seems to use a multiple of BV when doing buybacks. Before Covid the buybacks seemed to occur when Berkshire got below 1.2 times BV. Now the post Covid buybacks seem to occur when Berkshire gets below 1.1 times BV.

That should be a good clue about when Berkshire is below intrinsic value. I just do not know what discount to intrinsic value Buffett looks for when doing the buybacks. Buffett had previously said that Berkshire's intrinsic value was above 1.4 times BV. Maybe that has dropped back to 1.4 or less in a Covid world.

When (if) we get past Covid. we will need to watch closely.

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