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The Science of Hitting
The Science of Hitting
Articles (675) 

Berkshire Hathaway: Estimating Earnings Power

A review of Berkshire's operating segments in an attempt to calculate per share earnings power

Ive spent the past few months reading Warren Buffett (Trades, Portfolio)s letters to shareholders from the past 50 years. This is the first time Ive read the letters from start to finish in chronological order, and I think it was a revealing exercise. Ill have plenty to say about this over the coming months (I also have notes that Ill gladly share with anyone who is interested just message me with your email address).

One of the most notable changes at Berkshire Hathaway (BRK.B) in the past 10 to 15 years has been the explosive growth in the noninsurance operating businesses. This quote from the 2011 shareholder letter is a good example:

Each of our five largest noninsurance companies BNSF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy (MDPWK) delivered record operating earnings. In aggregate these businesses earned more than $9 billion pretax in 2011. Contrast that to seven years ago, when we owned only one of the five, MidAmerican, whose pretax earnings were $393 million.

In 2014, the Powerhouse Five reported $12.4 billion in pretax earnings (+38% from 2011).

As this shift continues, book value becomes even less relevant as a tool for estimating Berkshires intrinsic value. It would be helpful to take Buffett's two-column approach to estimating intrinsic value one step further: the goal of this article is to estimate all-in normalized earnings power at Berkshire Hathaway.

A few buckets

As I see it, we have a few items to consider: (1) the normalized earnings of the noninsurance businesses, (2) the normalized underwriting profits/losses of the insurance businesses, (3) the earnings attributable to Berkshire from its investments in equities and fixed income securities and (4) miscellaneous items, such as realized gains and losses from investments and derivatives.

Lets take these items in order.

Noninsurance businesses

This bucket has a lot of parts so Ill try and hit them relatively quickly.

The first is Burlington Northern Santa Fe, the railroad Berkshire acquired in 2010. In fiscal 2014, BNSF earned ~$3.9 billion in after-tax profits, a marginal increase from 2013 despite mid-single digit revenue growth. The lackluster gain in profitability reflects service- and weather-related issues BNSF faced in early 2014. Looking through the first nine months of 2015, profitability at the rail has increased 18% from the comparable period in 2014. Considering that the fourth quarter will likely be quite difficult (and probably 2016, too), lets take a decent-sized haircut and call full-year profit growth 10% for 2015. This implies profits of ~$4.3 billion in 2015.

Next, lets look at Berkshires Utility & Energy businesses. In 2014, these businesses reported ~$1.9 billion in after-tax earnings for Berkshire. Through the first nine months of 2015, these businesses reported a 12% increase in profits; as such, Ill use 2015 profits of ~$2.1 billion.

On to the Manufacturing, Service and Retailing businesses: in 2014, these activities generated ~$4.5 billion in profits for Berkshire. Through the first nine months of 2015, profits have increased 5.5% at these businesses, putting them on track for ~$4.7 billion for the full year.

Finally, we have the Finance & Financial Products businesses (primarily Clayton, UTLX and XTRA). In 2014, these businesses earned ~$1.2 billion (after tax). Through the first nine months of 2015, the profitability of these businesses increased ~18% relative to the comparable period of 2014. Assuming that growth rate holds in the fourth quarter, these businesses will earn ~$1.5 billion in 2015 (this doesnt attribute any benefit to UTLX from the ~25,000 tank cars acquired from General Electrics (GE) leasing unit in September for ~$1 billion).

In aggregate, the noninsurance business should earn ~$12.5 billion for Berkshire in 2015.

Insurance underwriting

Next, we need to think about underwriting for the insurance segments. Historic results offer some help. In the past five years, Berkshires insurance businesses have generated an average underwriting gain of ~$1.2 billion (after tax); in the past three years, the average gain was ~$1.6 billion a year. Berkshires insurance businesses have reported underwriting profits for 12 consecutive years a streak that will be extended to 13 years shortly.

In addition, if you want to think about underwriting gains relative to earned premiums, its worth noting that earned premiums have increased in nine of the past 10 years; over the past decade, earned premiums across Berkshires collection of insurance businesses increased at a 7% CAGR.

Ill take a haircut on both the three- and five-year averages to account for the fact that we have not seen a truly disastrous year in some time (although 2011 was no walk in the park). For the sake of this exercise, Im assuming a normalized underwriting gain of $1 billion annually.

Investment income: Reported

Over the past three years (2012 to 2014), Insurance Investment Income at Berkshire was ~$3.4 billion, ~$3.7 billion and ~$3.5 billion. This income represents the interest and dividends earned from the investments held by Berkshires insurance businesses. While there are a number of moving parts here, it should be noted that this segment began including dividends from Berkshires investment in Restaurant Brands International (NYSE:QSR) Preferred Stock in 2015, which has helped offset continued low rates on Berkshires fixed income securities. Overall, Investment Income has grown at a low single-digit rate through the first nine months of 2015 (and was up 10% in the third quarter). Ill keep it flat with 2014 levels in our calculation.

Investment income: Pass-through

Berkshire holds a number of investments that generate sizable economic earnings for its owners. However, in the financials reported to shareholders, Berkshire only shows its share of dividends received from these investees (as captured in the prior section). The funds retained by Berkshires investees are not accounted for in the GAAP income statement.

As an example, the Big Four holdings American Express (AXP), Coca-Cola (KO), IBM (IBM) and Wells Fargo (WFC) distributed ~$1.7 billion in dividends to Berkshire in 2014 (based on year-end ownership stake). This measure completely overlooks ~$3.2 billion in additional earnings that these businesses retained. For the sake of calculating pass-through earnings on an after-tax basis, I will assume that 100% of earnings are paid out as dividends. In this scenario, the overlooked earnings totaled ~$2.7 billion from the Big Four in 2014 (Im using a 14% tax rate based on a similar calculation Buffett used to do in the shareholder letter).

Berkshire Hathaway has other equity holdings outside of the Big Four. Ill spare you the calculation, but my math (which uses holding data from year-end 2014) estimates an additional ~$1.7 billion (pretax) in look-through earnings that do not show up in Berkshires investment income; using the 14% tax rate, thats an incremental ~$1.5 billion in after-tax profits.

Again, the dividends actually paid to Berkshire are accounted for in Insurance Investment Income. Ill add the value of the after-tax retained earnings a total of ~$4.2 billion to give us an idea of the normalized earnings power attributable to Berkshire from its investment portfolio.

Miscellaneous

We have a few more items to address before were finished.

The first is Investment & Derivative Gains/(Losses). This section includes gains/losses from the sale or redemption of investments, other-than-temporary impairment (OTTI) charges, and the changes in fair value from Berkshires credit default and equity put option contracts.

As we try and think about this, its helpful to start with some numbers: over the past five years, this line item has cumulatively added ~$11.2 billion in after-tax profits at Berkshire, or ~$2.2 billion a year. The company lost money in a single year over that period (~$500 million in 2011). Looking back five years earlier (2005 to 2009), Berkshire reported average Investment & Derivative Gains/(Losses) of ~$1.3 billion annually; its worth noting that this happened despite sizable reported derivative-related losses in 2008 from equity index put option contracts.

This is a bit of a gray area, but Im comfortable including the lower of the two figures (~$1.3 billion). If you would rather make this line zero, the impact is ~50 cents per share in EPS.

Our final consideration Other includes corporate income and expenses not allocated to the operating businesses. However, it also includes the investment in Heinz that generated ~$650 million in after-tax earnings in 2014. That investment, which is now a 26.8% interest in Kraft Heinz (KHC), will generate ~$750 million in annual dividends at the rate set in November 2015. Berkshire still holds preferred stock in the company that generates significant income (9% per annum), but this security is all but certain to be called in June of this year. Other cost ~$100 million in 2014; with the incremental dividend income, Ill call it a wash for 2015.

Conclusion

With that, we just need to do some simple addition and division. We have ~$12.5 billion from the first bucket (noninsurance businesses), ~$1 billion from the second bucket (underwriting income from insurance businesses), ~$7.7 billion from the third bucket (total investment income) and ~$1.3 billion from the fourth bucket (miscellaneous/other).

In total, our estimate of normalized earnings is roughly $22.5 billion a year.

At the end of the third quarter, Berkshire had 1,643,316 equivalent Class A shares outstanding; multiplying by 1,500 results in 2.465 billion Class B equivalent shares.

Our estimate of ~$22.5 billion is equal to ~$9.10 in normalized earnings power per B share.

To that, lets also add Precision Castparts (PCP). The business generated ~$2.5 billion in pre-tax profits in 2014 or ~$0.70 per B share on an after-tax basis (assumes 30% effective rate).

In addition, Berkshire has roughly $27 billion in fixed maturity investments. The duration is relatively short, with three-quarters maturing within the next five years. Its worth keeping in the back of your mind that each 100 basis-point improvement in the yield on these fixed maturity investments adds another dime to Berkshires pretax profits (per B share).

In that same light, Berkshire has another $10 billion in excess cash on the books earning a pittance (after accounting for the cash outflow coming for PCP and Buffett's $20 billion buffer). If you assume Buffett ultimately puts this to use at a 5% annual yield (measured in earnings power), thats another 20 cents per B share. Accounting for the Kraft Heinz preferred (which has not been included in the income calculation) adds another ~$8 billion of cash to put to use.

Inclusive of Precision Castparts, I estimate normalized earnings of nearly $10 per B share.

With the stock at ~$125 per share, Berkshire trades at a low double digit multiple of normalized earnings power. Berkshire shares look quite attractive at these levels. Knowing that Buffett would love to buy the stock if it fell any further is quite comforting, too.

About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 5.0/5 (15 votes)

Voters:

Comments

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Great summary Science. Thanks for making a complicated process look simple. Best - Tom

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Tom - Thanks for the kind words! Something I've been wanting / needing to do for a while so figured it was time to finally get it done :)

batbeer2
Batbeer2 premium member - 4 years ago

Thanks for sharing.

My math is not nearly as precise as yours but I get very similar results on the back of my envelope.

>> With the stock at ~$125 per share, Berkshire trades at a low double digit multiple of normalized earnings power.

Yes.

I'd add that Berkshire's subsidiaries (companies like Heinz, PCP. Geico, BNSF.....) are above average as compared to the run-of-the-mill S&P500 member. As a group, Berkshire's holdings currently command a much lower multiple than the S&P500 index. At least one of them must be mispriced.

I'm not a hedging kind of guy but one would think going long Berkshre and shorting the S&P500 index in equal amounts should yield decent returns on equity over time. Since Berkshire's stock tends to hold up quite well in down markets, the strategy should work especially well in a crash.

claudio.pascual
Claudio.pascual - 4 years ago    Report SPAM

Hello,

thanks for the analysis. I would appreciate if you could explain to me these concepts:

gains/losses from the sale or redemption of investments: is this the gain/loss that BRK makes after selling an investment in comparison with what it aquired for?

other-than-temporary impairment (OTTI) charges: like recognized losses?

changes in fair value from Berkshire’s credit default and equity put option contracts: for the credits that BRK grants to others?

Sorry for my ignorance. Cheers!

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Batbeer2,

Couldn't agree with you more: I think you are getting better businesses for a better price relative to the market. I think your hedge idea sounds good, but like yourself that's not my game; going long Berkshire in a big way works just as well for me :) Thanks for the comment!

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Claudio,

Yes, the gains / losses are from the sale / redemption price relative to what Berkshire paid.

OTTI charges are for holdings Berkshire has where the market value has declined and there's reason to believe it might stay that way; just like it sounds, there are a number of assumptions associated with calcuating OTTI charges (business prospects, creditworthiness of issuer, etc).

Finally, Berkshire has a few credit default and equity index put option contracts that they wrote 5+ years ago. The change in fair value from these positions is reported in the income statement each quarter. As Warren noted in the 2014 shareholder letter, they are unlikely to do so again in the future since newly written contracts require full collateralization.

Hope that helps!

claudio.pascual
Claudio.pascual - 4 years ago    Report SPAM

Hi The Science of Hitting,

it was very kind for you to answer my questions. Now If have it clearer and learned new things by the way.

Hope to read more articles from you soon.

Cheers!

William Barnes
William Barnes - 4 years ago    Report SPAM

Nice article, I also think it's a pretty attractive price here. Have you seen Gaynor's method of valuing Berkshire? Pretty back of the envelope but simple way to look at the valuation.

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Claudio,

No problem! I look forward to hearing from you in the future.

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Wbarnes,

I've seen it, but never actually worked out the math; just did it and got to an average for the three outputs of ~$165 per share. Personally, I think that's a realistic number. Thanks for the comment!

bajjiblow
Bajjiblow - 4 years ago    Report SPAM

Hello ,

Thanks for another great article !! I am interested to look at your notes you created from Berkshire Hathaway annual letters. I would appreciate if you could email them to [email protected]

Regards,

Ben

Bartdebock
Bartdebock - 4 years ago    Report SPAM

Hello, really nice article. Would you be so kind to mail me your notes to [email protected] Thanks

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

At this point, I've emailed the notes to everyone who has contacted me. However, I think I'm having issues with my email account for some unknown reason. If you've asked for the notes and I have not got back to you, please send me another message; my apologies if that's the case!

svmiura
Svmiura premium member - 4 years ago

A very lucid article, I would love to read your notes too. ([email protected])

Being long BRK in the current climate is not the worst position we could be in, especially with Buffett willing to buy back shares if they dip below what he sees as fair value.

Thanks

Phil

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Phil,

I just sent you an email; let me know if there are any issues. As it relates to Berkshire, I couldn't agree more; I think investors buying at current levels will do just fine :)

Thanks for the comment!

usamcal
Usamcal premium member - 4 years ago

A very useful article. As I am about to start reading the collection of Buffett letters to shareholders, reading your notes would be very much appreciated ([email protected]). Thank you in advance for your kindness.

carson
Carson - 4 years ago    Report SPAM

hi mate, very nice article to read. I think i will start reading some Buffett letters now, just not sure if an amateur investor like me can get to understand his language. I would love to read your notes too ([email protected]). Look forward to your notes and i will get back to you if i've got anything to ask or comment. Cheers.

h
H - 3 years ago    Report SPAM

Hi Science,

excellent article! Can you please send me your notes to BRK annual letters (the ones you had mentioned in the article)? You can send them to me at [email protected]

Many thanks!

Please leave your comment:



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