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Valuating Berkshire Hathaway Holdings: General Electric Company (GE)

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kfh227
Sep 17, 2009
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General Electric Company has had a nice run up in share price over the past 3 days. Running up from $14.70 to $17.00 or about 16% in that time span. The question is, why has one of Berkshire Hathaway’s current holdings, GE, run up so much so quickly. Perhaps GE was irrationally undervalued? One problem may be that GE is involved in many cyclical businesses and this might be part of the changing tide. Maybe people are coming into more and more agreement every day that the recession is over or that housing might be on the mend. Whatever the case, does GE provide an opportunity to the investor?


Warren Buffett seems to be a fan of GE. He has recently said that "GE is the symbol of American business to the world" and that "General Electric is the backbone of American industry. They have strong global brands and businesses with which I am quite familiar. They're going to be around in five or 10 or 100 years from now and if you buy at the right time, you'll probably make some money."


It is clear that Buffett thinks GE will be around for a long time. Also, Berkshire Hathaway has injected $3 billion into GE via preferred stock. Berkshire Hathaway also holds about 7.8 million shares of GE common stock.


With all of this, one simple question needs to be answered. Or in the case of GE, a not so simple question. What is the General Electric Company worth?


GE floated at around $40/share for most of the past decade. Since 2001, GE shares have steadily risen from $30 to about $40 prior to its drop to the low teens and even single digits during a short time in March 2009. Has the tide risen to much or is it just the beginning? This article will discuss the value of general electrical using a discounted cash flow valuation and PE ratios.


Valuation – The PE ratio way.

When talking earnings, always look at several years of data and use long term average. This is known as normalizing earnings. There is not right way or wrong way to normalize numbers. But earnings need to be normalized because Generally Accepted Accounting Principles (GAAP) can cause any single year of earnings to look very good or very bad. Remember, earnings for a given single year only give an account of what happened in that given year. They do not tell you what the company is worth.


Earnings are as follows for the past 5 years:


2008: $1.78

2007: $2.20

2006: $1.99

2005: $1.72

2004: $1.59



The average EPS for these 4 years is $1.85. A multiple of 15 is acceptable for GE stock. So, GE is worth about $27.75 using a simple PE calculation.


Valuation – The DCF way.

GE is difficult to value due to its financial arm. It might be best to assume that GE has no financial arm and determine what the non-financial arm is worth and use that as intrinsic value. In essence, assuming that the financial arm has no value or fractional value of what one calculates independently. Truth of the matter is that the financial arm has a value. Even if GEs financial arm would have failed during the recent turmoil, one thing needs to be remembered. The financial arm is part of a greater whole. The economics of the two arms (financial and non-financial) meld together to form that greater whole.


When the economy recovers, the financial arm will behave just as it had during the economies normal years. For the purpose of this article, I will leave everything alone (making no adjustments for the financial arm) and give a best estimate valuation.


Over the past 10 years, GEs free cash flows (FCF) have grown at a rate of about 10% annually. My assumptions for the future of FCF are as follows. I am assuming that FCF will drop to $20 billion next year. This is a significant drop in FCF since 2008. I am assuming no growth for year 2. Then 10% growth for 3 consecutive years (years 3, 4 and 5). And for the last 5 years, growth of 9.5%, 9.0%, 8.5%, 8.0% and 7.5% were used. Terminal growth (years beyond year 10) is estimated at 4%. A discount rate of 9% was used. By adding the future free cash flows to today's dollars using the 9% discount rate,it was determined that GE is worth about $390 billion. GEs current market cap is $180 billion.


According to the most recent 10-Q filed by GE, it can be discovered that there are 10,626,842,000 shares of GE stock. Some risk of dilution does exist, so a 2% dilution of stock is to be assumed. So 10,839,378,840 shares will be assumed for the DCF calculation.


Through simple division, it can be concluded that GE is worth about $36/share via a DCF calculation.


Conclusion:

Two valuations were done. A basic PE ratio and a more advanced DCF calculation. Via PE ratios, it was deduced that GE is worth $27.50 and using a DCF calculation it was determined that GE is worth $36/share.


At current quote of $17, either valuation methodology shows that GE represents an opportunity. $17 represents a discount of over 50% to the DCF intrinsic value calculation of $36. The PE ratio valuation shows a 38% discount to intrinsic value.


By combining Warren Buffett’s thoughts on GE and the fact that this is an apparent bargain, perhaps it is time to buy GE stock.


Disclosure: The author of this article owns GE stock.



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