I figured I needed a title to match the sensationalism of Barron's "Sell Buffett" headline. They say Berkshire Hathaway is overvalued, I disagree. I do own and have owned Berkshire shares for many years, and along the way have spent a great deal of time studying the Great One and pondering how to value his creation.
Barron's concludes BRK is overvalued based on book value multiples and earnings multiples relative to 5-year averages. Boy, that was easy! Plus, they have opinions from two Wall Street analysts to back them up. Barron's states that only a few analysts cover BRK because management won't talk to analysts. Or it could be that they are unlikely to get any investment banking business from Berkshire, and trading volumes in the stock are low, so what's in it for them? For the record, that's my guess. I used to get research from one of the analysts cited in the article, and it was awful from a valuation standpoint. Plus, if I recall, he has been negative from day one while Berkshire's stock has climbed merrily. I would note that one analyst cited "lack of clear management succession" as an issue. Yes Buffet's old. No he hasn't let the cat out of the bag as to who will replace him. Yes he knows who they will be. Yes they will be good. Stop whining.
What the heck is Berkshire anyway? Is it a cobbled-together conglomerate of unrelated old-school businesses? Nope - it's a compounding machine that magically generates billions and billions of dollars that can then be reinvested by one of the greatest investors ever. Buffett simply buys businesses that are likely to generate tons of cash for a long time. He pays a cheap price for them, and then he gets to spend the money they generate on more cash producers.
How does one value Berkshire? I will toss out three methods here that I use: 2 simple ones and one fairly complex method. Each one is blessed, in one way or another, by Buffett himself.
A very simple method is assigning a multiple to book value. Hey - didn't Barron's do that too? Yes, but the basis for their multiple was the average of the last five years. That assumes that BRK has on average been fairly valued during that time. It hasn't. But Buffett himself gives us clues to the appropriate multiple. Buffett frequently states in his annual reports that:
"...we give you Berkshire's book value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire's intrinsic value."
So we know that he thinks intrinsic value tracks book value, and that IV is significantly greater than book. I believe he also told us at least once when he thought his stock was fairly valued. The time was mid 1996 when he issued class B shares.
"When we sold Class B shares in 1996, we stated that Berkshire stock was not undervalued... (We did NOT (Buffett's emphasis), however, say at the time of the sale that our stock was over valued, though many media have reported that we did.)"
Sounds like he thought the shares were fairly valued. At the time, the stock was trading at approximately 2.2x book, or 2.5x tangible book. If we slap those multiples on the most recently reported book values, we get intrinsic value to be $142000 per A share (2.5x tangible book) or $172000 (2.2x book), or an average of about $157000. At worst, BRK is fairly valued based on this simple model.
A second simple model is that espoused by T2 Partners. The principals, Whitney Tilson and Glenn Tongue are long-time Buffett watchers. They believe that Buffett has intimated several times that the company should be valued at 12x pretax earnings (excluding investment gains) plus the total value of investments. As stated in the Barron's article, that gives a current IV of $167000 per share.
However, in my opinion (and Buffet's I believe) the real deal model is float-based valuation. A version of this model is used by the Buffett afficionados at Fairholme Capital Management. Buffett himself said at the 1992 shareholders' meeting that:
"If you could see our float for the next 20 years and you could make an estimate as to the amount and the cost of it, and you took the difference between its cost and the returns available on governments you could discount it back to a net present value."
I base my float model on the work of one Alice Schroeder. Who? None other than Buffet's biographer, currently collaborating with Buffett to write his first official bio (to be released in 2008). She also used to be one of the most respected insurance analysts on Wall Street, and one of the only ones who ever had any access to Buffett. Clearly she has received a strong endorsement from Buffett himself, which is good enough for me. I have an old report she wrote on Berkshire in 1999 when she was at Paine Webber (she subsequently worked at Morgan Stanley), that details her model. Although I use different assumptions, the framework is the same.
Float is the key to Berkshire's kingdom. Berkshire is largely a giant insurance company, including GEICO and General Re. Simply put, the insurance businesses are a way for Buffett to borrow investment capital forever, for free. Float is simply the cash that policy holders pay you today to cover risks that might not happen for a long time, if at all. Berkshire currently holds $59 billion of float from which it generates investment returns. Float is only free if the insurance business is able to balance its current costs (losses and operating costs) with its current income, which requires great expertise in underwriting and pricing risk, as well as discipline and business execution. The Berkshire insurance businesses have proven that they can generate zero-cost float, and in fact float has had a negative cost for the past five years. In other words, Buffett has been paid to accept investment capital. This is akin to your broker paying you a few percent to borrow money from them, and oh yeah, you never have to pay it back. As long as the insurance businesses don't shrink over time, float never has to be "paid back".
You can see why Buffett loves float. To value Berkshire based on float, you have to decide what $59 billion of float is worth, based on the returns it will generate over time and the growth of the float. Float growth has averaged about 7% annually over the past five years (although it's up 16% ytd), and we all know about Buffett's spectacular investment returns. However, in my model I assume mid single digit float growth, giving little value to Buffett's ability to achieve higher returns. I value the float at about $110B. To this I add the insurance capital (statutory surplus), less goodwill, and then add half of the deferred tax reserve (since Buffett holds his investments indefinitely, most of these taxes on unrealized gains will not be paid any time soon). For this piece I get a value of about $53 billion.
Finally, we must value the other businesses. For this I will use a simple multiple of pretax earnings. T2's 12x seems as good as any, giving a value of $81B for the non-insurance businesses.
Clearly a model like this is highly subject to input values and assumptions. My rule is to try and use conservative values at every step, building in a margin of safety. I never know what the valuation will be until the final values are entered, and then I have to live with it. If the IV comes out low, so be it. My float-based IV then is $244 billion. This is equivalent to $157000 per A share or $5260 per B share. Again, this is well above Barron's estimate of around $130000 per share. It is also not far from the valuations obtained using the simpler models.
Conclusion? Berkshire is probably undervalued by 10-20% at these levels. Maybe it's not cheap enough to buy depending on your required margin of safety, but in my opinion it's far from a sell.
Barron's concludes BRK is overvalued based on book value multiples and earnings multiples relative to 5-year averages. Boy, that was easy! Plus, they have opinions from two Wall Street analysts to back them up. Barron's states that only a few analysts cover BRK because management won't talk to analysts. Or it could be that they are unlikely to get any investment banking business from Berkshire, and trading volumes in the stock are low, so what's in it for them? For the record, that's my guess. I used to get research from one of the analysts cited in the article, and it was awful from a valuation standpoint. Plus, if I recall, he has been negative from day one while Berkshire's stock has climbed merrily. I would note that one analyst cited "lack of clear management succession" as an issue. Yes Buffet's old. No he hasn't let the cat out of the bag as to who will replace him. Yes he knows who they will be. Yes they will be good. Stop whining.
What the heck is Berkshire anyway? Is it a cobbled-together conglomerate of unrelated old-school businesses? Nope - it's a compounding machine that magically generates billions and billions of dollars that can then be reinvested by one of the greatest investors ever. Buffett simply buys businesses that are likely to generate tons of cash for a long time. He pays a cheap price for them, and then he gets to spend the money they generate on more cash producers.
How does one value Berkshire? I will toss out three methods here that I use: 2 simple ones and one fairly complex method. Each one is blessed, in one way or another, by Buffett himself.
A very simple method is assigning a multiple to book value. Hey - didn't Barron's do that too? Yes, but the basis for their multiple was the average of the last five years. That assumes that BRK has on average been fairly valued during that time. It hasn't. But Buffett himself gives us clues to the appropriate multiple. Buffett frequently states in his annual reports that:
"...we give you Berkshire's book value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire's intrinsic value."
So we know that he thinks intrinsic value tracks book value, and that IV is significantly greater than book. I believe he also told us at least once when he thought his stock was fairly valued. The time was mid 1996 when he issued class B shares.
"When we sold Class B shares in 1996, we stated that Berkshire stock was not undervalued... (We did NOT (Buffett's emphasis), however, say at the time of the sale that our stock was over valued, though many media have reported that we did.)"
Sounds like he thought the shares were fairly valued. At the time, the stock was trading at approximately 2.2x book, or 2.5x tangible book. If we slap those multiples on the most recently reported book values, we get intrinsic value to be $142000 per A share (2.5x tangible book) or $172000 (2.2x book), or an average of about $157000. At worst, BRK is fairly valued based on this simple model.
A second simple model is that espoused by T2 Partners. The principals, Whitney Tilson and Glenn Tongue are long-time Buffett watchers. They believe that Buffett has intimated several times that the company should be valued at 12x pretax earnings (excluding investment gains) plus the total value of investments. As stated in the Barron's article, that gives a current IV of $167000 per share.
However, in my opinion (and Buffet's I believe) the real deal model is float-based valuation. A version of this model is used by the Buffett afficionados at Fairholme Capital Management. Buffett himself said at the 1992 shareholders' meeting that:
"If you could see our float for the next 20 years and you could make an estimate as to the amount and the cost of it, and you took the difference between its cost and the returns available on governments you could discount it back to a net present value."
I base my float model on the work of one Alice Schroeder. Who? None other than Buffet's biographer, currently collaborating with Buffett to write his first official bio (to be released in 2008). She also used to be one of the most respected insurance analysts on Wall Street, and one of the only ones who ever had any access to Buffett. Clearly she has received a strong endorsement from Buffett himself, which is good enough for me. I have an old report she wrote on Berkshire in 1999 when she was at Paine Webber (she subsequently worked at Morgan Stanley), that details her model. Although I use different assumptions, the framework is the same.
Float is the key to Berkshire's kingdom. Berkshire is largely a giant insurance company, including GEICO and General Re. Simply put, the insurance businesses are a way for Buffett to borrow investment capital forever, for free. Float is simply the cash that policy holders pay you today to cover risks that might not happen for a long time, if at all. Berkshire currently holds $59 billion of float from which it generates investment returns. Float is only free if the insurance business is able to balance its current costs (losses and operating costs) with its current income, which requires great expertise in underwriting and pricing risk, as well as discipline and business execution. The Berkshire insurance businesses have proven that they can generate zero-cost float, and in fact float has had a negative cost for the past five years. In other words, Buffett has been paid to accept investment capital. This is akin to your broker paying you a few percent to borrow money from them, and oh yeah, you never have to pay it back. As long as the insurance businesses don't shrink over time, float never has to be "paid back".
You can see why Buffett loves float. To value Berkshire based on float, you have to decide what $59 billion of float is worth, based on the returns it will generate over time and the growth of the float. Float growth has averaged about 7% annually over the past five years (although it's up 16% ytd), and we all know about Buffett's spectacular investment returns. However, in my model I assume mid single digit float growth, giving little value to Buffett's ability to achieve higher returns. I value the float at about $110B. To this I add the insurance capital (statutory surplus), less goodwill, and then add half of the deferred tax reserve (since Buffett holds his investments indefinitely, most of these taxes on unrealized gains will not be paid any time soon). For this piece I get a value of about $53 billion.
Finally, we must value the other businesses. For this I will use a simple multiple of pretax earnings. T2's 12x seems as good as any, giving a value of $81B for the non-insurance businesses.
Clearly a model like this is highly subject to input values and assumptions. My rule is to try and use conservative values at every step, building in a margin of safety. I never know what the valuation will be until the final values are entered, and then I have to live with it. If the IV comes out low, so be it. My float-based IV then is $244 billion. This is equivalent to $157000 per A share or $5260 per B share. Again, this is well above Barron's estimate of around $130000 per share. It is also not far from the valuations obtained using the simpler models.
Conclusion? Berkshire is probably undervalued by 10-20% at these levels. Maybe it's not cheap enough to buy depending on your required margin of safety, but in my opinion it's far from a sell.
