The per-share market value of Berkshire Hathaway Inc. (BRK.A, Financial)(BRK.B, Financial) has grown by 20.1% annually since 1965, but at current interest rates its growth prospects remain mediocre in my view. Berkshire’s growth, in its book value and free cash flow, has slowed down because of rising interest rates affecting its marketable securities and operating businesses. Its stock had lost about 40% from its peak in March 2022 and has not fully recovered yet. The stock at its current price and prevailing interest rates is trading close to my estimate of its intrinsic value, which is why I believe it remains unattractive to most value investors.
In 2007, when interest rates were 5% or thereabout, similar to the situation we are witnessing today, Warren Buffett (Trades, Portfolio), the most successful investor and chairman of Berkshire, said that “the compounded intrinsic value growth for Berkshire over the last 10 years has been 10% and expected this rate to continue to grow at the same rate if interest rates remained at the same levels generating 30-40% in cash in the next decade or so."
Rising interest rates
Although the interest rates since 2007 declined to 1%-2% for more than a decade between 2009 to 2021, today they are back to 5% again in January 2023.
The increasing interest rates have negatively affected Berkshire’s intrinsic value and slowed down its growth prospects for the next 10 years or so. Buffett has been consistent with his predictions because even in 1999 he said something similar. He said, “Berkshire’s book value and free cash flows are expected to grow at 11-15% for the next 10-20 years." Coincidentally, this time around the interest rates were hovering around 5% again.
Today, Berkshire’s stock price for its Class B shares is down by about 17% from its peak of $362 in March 2022. This decline is attributed to rapidly increasing interest rates by the Federal Reserve and the newly introduced Generally Accepted Accounting Principles (GAAP) rules to report earnings by Financial Accounting Standards Board (FASB) that resulted in an earnings loss reported by Berkshire in 2022. The short-term interest rates are fully inverted, which suggests a high rate of inflation, unemployment, and slowing economic growth prospects in the U.S. and which has started affecting many businesses.
*Note: Berkshire’s Class B shares used for the analysis in this article are equivalent to 1/1500 of Class A shares.
Earnings loss
Berkshire reported a loss of $40.37 billion for the nine months period ending on 30 September 2022 as compared to a $50.90 billion profit for the same period in 2021.
In the first nine months of 2022, Berkshire reported a net unrealized loss of $80.5 billion resulting from its marketable securities versus unrealized gains of $36.2 billion for the same period in 2021. To a large extent, these losses are attributed to unrealized losses from Berkshire’s equity securities because of the changes in GAAP reporting rules.
Change in reporting rules
The new GAAP rules introduced in 2018 required that businesses holding equity securities as investments must report their unrealized gains or losses in their earnings resulting from market fluctuations. Warren Buffett (Trades, Portfolio), in his annual letter to shareholders in 2019, warned against new reporting rules by saying that “the new GAAP reporting standards are meaningless for analytical and predictive purposes because of volatility in the short term.” Yet it is obvious that analysts and investors have not paid heed and downgraded and abandoned Berkshire’s stock in 2022.
Berkshire for this reason touched a low of $259 per B share in October 2022. Berkshire’s situation today warrants that we ignore the noise and objectively analyze its performance to arrive at a fair value to be able to decide whether the stock is trading down merely because of new reporting standards, rising interest rates, or in fact, there is a material change in its fundamentals which is affecting its performance and worrying investors.
As Benjamin Graham once said, “In the short run, a market is a voting machine but in the long run, it is a weighing machine.”
Converging market price and intrinsic value
If we analyze Berkshire’s performance using its book value growth for the last 10 years and apply a conservative discount rate, we get an intrinsic value estimate of $297 per B share, as shown in the chart below:
There is an important point to note, though. The book value considered for my calculation of intrinsic value does not include Berkshire’s share of retained earnings from its investee businesses. For example, in 2018 in its Annual General Meeting (AGM), Buffett said that “the retained earnings from Berkshire’s investee companies are not included in its balance sheet." This emphasizes the importance of Berkshire’s share of retained earnings from its non-controlling businesses when estimating Berkshire’s intrinsic value.
For this reason, in 2019, Buffett revealed Berkshire’s share of retained earnings from its marketable securities in the annual report and shareholder letter. Berkshire had about $8.3 billion as its share of retained earnings from its publicly listed securities that it owns.
If we factor that in for our calculation of Berkshire’s book value, it will not make any significant difference. For example, adding back this amount to the shareholder’s equity will give us a book value of $214. Using the same discount rate of 5% will give us an intrinsic value of $308 which is still below its current price of $310. This perhaps was one of the reasons why Berkshire scaled back its repurchases in 2022 because the stock at this level was trading at its intrinsic value and did not provide any margin of safety to Buffett and investors.
In 2019, Berkshire changed its buyback policy according to Berkshire’s annual report and its letter to shareholders. Berkshire linked its repurchases to its intrinsic value estimate and not the book value anymore. Prior to this Berkshire had a policy of buying back only if the stock traded 1.2 times its book value or below.
Berkshire in 2021 had a market cap of $663 billion and total shareholder’s equity of $514 billion versus a market cap of $682 billion and total equity of $463 billion by the end of September 2022. This marginal decline of about 3% in shareholder’s equity was perhaps because of a small number of share buybacks.
Furthermore, Berkshire scaled back its repurchases by spending a total of $5 billion in 2022 as compared to $27 billion in 2021 and $25 billion in 2020. This confirms our hypothesis that the regression in stock buybacks was perhaps because it was trading above or close to its intrinsic value.
“Market price and intrinsic value often follow very different paths – sometimes for extended periods – but eventually they meet," Buffett stated in his 2011 shareholder letter.
Now let’s turn to another method of valuing Berkshire based on its free cash flows for the last 10 years. Berkshire’s free cash flows have been growing at a 10% clip annually for the last 10 years. Berkshire today has close to $100 billion in cash which includes its investments in the U.S. short-term government bonds and treasury bills.
When analyzing free cash flows, we discount back Berkshire’s free cash flows for the last 10 years at 6% to find its present value. After that, we apply a conservative rate of 4% and 2% respectively (adjusted for inflation) on its future cash flows to estimate its future cash flows, and we get a figure of $456.8 billion (CAGR: 35%). There is no doubt that Berkshire with $100 billion in cash will reach that figure sometime in the future. In fact, Buffett himself said that in 2017 “ my successors will have $400 billion cash to invest in the next decade.” This is again in line with what he had said in 2007 "the cash flows could grow by 30%-40% in the next decade or so if interest rates remained at 5%."
That’s about the future. But the intrinsic value that we get right now still is $298 per B share with a negative margin of safety when we use conservative discount rates for calculating the value of past and future free cash flows.
Conclusion
We have used two different methods to estimate the fair value of Berkshire. It is evident in my view that there was a consensus between Buffett, the analysts, and investors in 2022 in estimating the intrinsic value of Berkshire. No wonder Berkshire did not make any significant repurchases in 2022!
Otherwise, I find no other compelling reason to believe why Berkshire scaled back its aggressive buyback program it started a couple of years ago. There is no doubt that the new GAAP accounting and reporting rules coupled with the fear of recession because of inverted yield curve as a result of short-term rising interest rates might have influenced and played a role in dissuading Buffett and investors from buying the stock. I believe it is also because the market price and intrinsic value of Berkshire which have converged.
