Berkshire Hathaway Intrinsic Value Revisited

“If you want to guarantee yourself a lifetime of misery, be sure to marry someone with the intent of changing their behavior.” —Charlie Munger

Shareholder Letter and Annual Report 2015

Today Warren Buffett’s yearly letter to shareholders was published (click here to read). At the same time the Berkshire annual report for fiscal year 2015 was released (click here for the annual report.

For anyone interested in business analysis and investing this letter should not be left unread. I will not dwell on the content in the letter, except for updating my current estimate of per-share intrinsic business value.

Below, some financial key metrics for the past five years that you will find on page 34 in the annual report.

Per-share book value (for both Class A and Class B stock) increased with 6.4 % during 2015 to $155,501 (Class A) and $103.67 (Class B).

In the section “Intrinsic Business Value,” Warren discusses the qualitative factors used in valuing Berkshire. As always he emphasizes the inherent uncertainty that applies to all kinds of valuations.

As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock). It is possible, however, to make a sensible estimate. In our 2010 annual report we laid out the three elements – one of them qualitative – that we believe are the keys to an estimation of Berkshire’s intrinsic value.

In the next paragraph Warren provides two critical inputs to a per share intrinsic business value per share: 1) per-share cash and investments of $159,794, and 2) pre-tax earnings from our many businesses (including insurance underwriting income) of $12,304 per share. This is the first year that insurance underwriting income has been included in the earnings figure.

I used the italics in the paragraph above because we are for the first time including insurance underwriting income in business earnings. We did not do that when we initially introduced Berkshire’s two quantitative pillars of valuation because our insurance results were then heavily influenced by catastrophe coverages. If the wind didn’t blow and the earth didn’t shake, we made large profits. But a mega-catastrophe would produce red ink. In order to be conservative then in stating our business earnings, we consistently assumed that underwriting would break even over time and ignored any of its gains or losses in our annual calculation of the second factor of value.

Today, our insurance results are likely to be more stable than was the case a decade or two ago because we have deemphasized catastrophe coverages and greatly expanded our bread-and-butter lines of business. Last year, our underwriting income contributed $1,118 per share to the $12,304 per share of earnings referenced in the second paragraph of this section. Over the past decade, annual underwriting income has averaged $1,434 per share, and we anticipate being profitable in most years. You should recognize, however, that underwriting in any given year could well be unprofitable, perhaps substantially so.

Intrinsic Value

In the table below I have updated my rough valuation using the data as reported by Berkshire as of today (see links above).

Before this update my rough estimate of per-share intrinsic business value (IBV) per share was $168 per B-share, equal to $252,000 per A-share. The updated IBV per share below was calculated using the so-called two bucket approach, that is per-share cash and investments plus pre-tax earnings times chosen earnings multiple.

A 10x earnings multiple is equal to approximately a 15x after-tax earnings multiplier.

Using a 10x pre-tax multiple without including any insurance underwriting income results in a per-share IBV of $181 per B-share, equal to $271,654 per A-share. If one were to include insurance underwriting income the per-share IBV would increase to 189 per $B-share, equal to $282,834 per A-share.

As for now I will update my watch list with the IBV per B-share excluding insurance underwriting income, that is $181, let’s round it down to $180.

Earlier I have used a price-to-book multiple of 1.65 times. At 1.65 times book the current value per share is $171. A price to book multiple of 1.65 looks like a reasonable multiple compared to the past, and it might even be a bit conservative compared to the values in the table below. So for now I will keep the 1.65 times multiple as rough proxy.

Buffett himself is willing to repurchase stock at a price to book of 1.2 or lower. Assuming Buffett is willing to repurchase Berkshire stock at 2/3 of intrinsic value, this would imply a price to book multiple of 1.8 times, pretty much in line with the per share IBV when using a 10x pre-tax earnings multiplier (including insurance underwriting income) and adding per-share cash and investments.

A reasonable range for the IBV per B-share looks to be about $104 to $189 ($155,501 to $282,834 per A-share).

For your attention I made my first purchase of B-shares back on September 8, 2015, when the market price was $132.21 per share, slightly above the closing market price of yesterday.

Disclosure: I have a position in the BRK.B stock mentioned. I am not receiving compensation for it. I have no business relationship with the company. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.

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Is Berkshire a Buy at the Current Price to Book Value?

“The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another.” —Warren Buffett, Letter to Shareholders, 2011

Mr. Market’s Current View of Berkshire Hathaway

With Berkshire’s stock (NYSE: BRK.B) cnow trading at $ 129,61 down about 14% so far in 2015, it’s trading at a price to book value multiple of 1,29, not too far above the price limit of 120% of price to book value that’s used as a reference point by Warren and Charlie for when share repurchases are deemed to be favorable for continuing shareholders.

The table below shows Berkshire’s book value per B-share and price data going back ten years.

To get a better idea of Warren’s thinking when it comes to buying back Berkshire stock, let’s turn to his letter to shareholders in 2011 and 2012, where he shares his view on this subject, i.e. share repurchases (emphasis added).

The Original Buyback Limit – 110%

In 2011 Berkshire announced that they would buy back its own shares if price falls below 110 percent of book value. In his Letter to Shareholder in 2011 Warren shared his thought on share repurchases and the established limit price.

“We have no way to pinpoint intrinsic value. But we do have a useful, though considerably understated, proxy for it: per-share book value. This yardstick is meaningless at most companies. At Berkshire, however, book value very roughly tracks business values. That’s because the amount by which Berkshire’s intrinsic value exceeds book value does not swing wildly from year to year, though it increases in most years. Over time, the divergence will likely become ever more substantial in absolute terms, remaining reasonably steady, however, on a percentage basis as both the numerator and denominator of the business-value/book-value equation increase.”

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Share Repurchases

Last September, we announced that Berkshire would repurchase its shares at a price of up to 110% of book value. We were in the market for only a few days – buying $67 million of stock – before the price advanced beyond our limit. Nonetheless, the general importance of share repurchases suggests I should focus for a bit on the subject.

Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.

We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another. (One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; I recommend that you read his annual letter.)

Charlie and I have mixed emotions when Berkshire shares sell well below intrinsic value. We like making money for continuing shareholders, and there is no surer way to do that than by buying an asset – our own stock – that we know to be worth at least x for less than that – for .9x, .8x or even lower. (As one of our directors says, it’s like shooting fish in a barrel, after the barrel has been drained and the fish have quit flopping.) Nevertheless, we don’t enjoy cashing out partners at a discount, even though our doing so may give the selling shareholders a slightly higher price than they would receive if our bid was absent. When we are buying, therefore, we want those exiting partners to be fully informed about the value of the assets they are selling.

At our limit price of 110% of book value, repurchases clearly increase Berkshire’s per-share intrinsic value. And the more and the cheaper we buy, the greater the gain for continuing shareholders. Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower. You should know, however, that we have no interest in supporting the stock and that our bids will fade in particularly weak markets. Nor will we buy shares if our cash-equivalent holdings are below $20 billion. At Berkshire, financial strength that is unquestionable takes precedence over all else.

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This discussion of repurchases offers me the chance to address the irrational reaction of many investors to changes in stock prices. When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well. A corollary to this second point: “Talking our book” about a stock we own – were that to be effective – would actually be harmful to Berkshire, not helpful as commentators customarily assume.” (Source: Letter to Shareholders, 2011)

A Revised Buyback Limit – 120%

In his Letter to Shareholders in 2012 Warren again discussed the issue of share repurchases in light of Berkshire’s decision to increase the buyback limit to 120% of book value per share.

“One thing of which you can be certain: Whatever Berkshire’s results, my partner Charlie Munger, the company’s Vice Chairman, and I will not change yardsticks. It’s our job to increase intrinsic business value – for which we use book value as a significantly understated proxy – at a faster rate than the market gains of the S&P. If we do so, Berkshire’s share price, though unpredictable from year to year, will itself outpace the S&P over time. If we fail, however, our management will bring no value to our investors, who themselves can earn S&P returns by buying a low-cost index fund. 

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The third use of funds – repurchases – is sensible for a company when its shares sell at a meaningful discount to conservatively calculated intrinsic value. Indeed, disciplined repurchases are the surest way to use funds intelligently: It’s hard to go wrong when you’re buying dollar bills for 80¢ or less. We explained our criteria for repurchases in last year’s report and, if the opportunity presents itself, we will buy large quantities of our stock. We originally said we would not pay more than 110% of book value, but that proved unrealistic. Therefore, we increased the limit to 120% in December when a large block became available at about 116% of book value.

But never forget: In repurchase decisions, price is all-important. Value is destroyed when purchases are made above intrinsic value. The directors and I believe that continuing shareholders are benefitted in a meaningful way by purchases up to our 120% limit.” (Source: Letter to Shareholders, 2012)

Conclusion

I will leave the question about whether or nor Berkshire is a buy at the current price unanswered, because this is a decision that you have to make on your own. But, I think Berkshire’s stock price at the moment makes this a relevant question to ask: Is Berkshire a Buy at the Current Price to Book Value?

Further Reading

Bloomberg Business: Buffett Expands Buyback to Pay Up to 120% of Book Value (December 12, 2012) 

Bloomberg Business: Berkshire to Buy Back Shares as Cash Exceeds $40 Billion (September 26, 2011)

Disclosure: I have no positions in any stocks mentioned. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.