Warren Buffett's Approach to Valuing Berkshire Hathaway

Some advice from the Oracle of Omaha on how he'd go about it

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Jun 28, 2019
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At the Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) 1999 annual meeting of shareholders, in the Q&A session, one shareholder asked Warren Buffett (Trades, Portfolio) for his views on how to calculate the company's intrinsic value, which led to an interesting conversation.

The shareholder, who stated he was Dan Kurs from Bonita Springs, Florida, explained the valuation approach he had been using to try to calculate Berkshire's intrinsic value. Kurs explained that he had been using Berkshire's total look-through earnings and adjust them for normalized earnings at the insurance business.

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"Then I've assumed that Berkshire's total look-through earnings will grow at 15% per annum on average for 10 years, 10% per annum for years 11 through 20. And that earnings stop growing after year 20, resulting in a coupon equaling year-20 earnings from the 21st year onward," the questioner went on to add.

He then said that he used a discount rate of 10% to get an estimate of the conglomerate's intrinsic value. After explaining his method, Kurs asked the Oracle of Omaha if his approach was sensible and if there was a more appropriate discount rate he should be using.

Buffett's response

While Buffett didn't want to comment on the earnings growth rates used in the calculation, he did say, "I couldn't state it better myself," when referring to the method. He also suggested that the shareholder might want to use a lower risk-free interest rate in the calculation considering "present-day" rates. Buffett went on to add:

"Now, that doesn't mean we would pay that figure once we use that discount number. But we would use that to establish comparability across investment alternatives.

So, if we were looking at 50 companies and making the sort of calculation that you just talked about, we would use a — we would probably use the long-term government rate to discount it back.

But we wouldn't pay that number after we discounted it back. We would look for appropriate discounts from that figure. But it doesn't really make any difference whether you use a higher figure and then look across them or use our figure and look for the biggest discount.

You've got the right approach. And then all you have to do is stick in the right numbers."

Unique insight

This is a fantastic insight into the way the Oracle of Omaha goes about valuing businesses. He has mentioned on many occasions that he uses a discount cash flow analysis to try estimate intrinsic value and that he looks to buy stocks at a discount of his assessment of intrinsic value, but the fact that he also compares the company's valuation to other companies throughout its sector and industry is relatively uncovered information.

Buffett always puts in a tremendous amount of work when valuing businesses, and this only reinforces the fact that he is not just picking stocks at random. These comments suggest that when he finds a potential investment opportunity, he values it against all of its peers.

Now, this shouldn't be mistaken for relative valuation. Buffett does not believe that relative valuation is appropriate for evaluating any securities because it does not take into account the individual strengths and weaknesses of the businesses being compared.

However, what I believe Buffett is trying to do by valuing all businesses is get some idea of the growth rates of these companies as well as their valuations. This appears to be part of his process to understand his target investment, what makes it stand out, and the competitive advantages it has over competitors.

You can't find all of the answers to these questions just by looking at the numbers, but they will point you in the right direction. Buffett's valuation framework is only part of a long and detailed process of valuation and company analysis. Unfortunately, there's no short cut.

Disclosure: The author owns shares in Berkshire Hathaway.

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