Case Study: Accounting vs. Economic Profit at GEICO

“Our calculus is different: We simply measure whether we are creating more than a dollar of value per dollar spent — and if that calculation is favorable, the more dollars we spend the happier I am.” —Warren Buffett

Accounting vs. Economic Profit: Acquisition of New Policy Holders

Sanjay Bakshi has written about Warren Buffett’s views about the decisions relating to customer acquisition costs for GEICO. Bakshi refers to an interview with Tom Russo “where he talked about the logic of Buffett’s decision to lay out large sums of money to acquire new, likely to be profitable customers for GEICO, even though such actions would severely penalise near term earnings.”

In this interview Tom Russo gives some insight as to how to think about the short-term earnings impact from acquiring additional policy holders, versus the change in intrinsic value (emphasis added).

When Warren Buffett bought GEICO, the company had something like two million policyholders, and Berkshire’s belief was that they were the best insurer in the country. So why should they have a bigger than two percent market share? And the answer was that every new policy that they put on the books reported losses to the firm of $250 of operating losses: reported losses at least when they would sign up for those new policies. And of course at the same time because of high persistency and because of the great business model of GEICO the net present value of each new insured was $1500. So when it was a separately run public company, GEICO was constrained by not being able to take the steps to grow the business optimally because they had to report a $250 loss for every new insured and they kind of measured their growth in the modest pace. Once it came inside of Berkshire, Warren who doesn’t really care about reporting profits, he was delighted to take steps that could increase the firm’s net present value by adding new policy holders even if it meant that in the year of acquisition, he showed more losses. And you have seen as anybody who has inhabited the earth over the past two decades would have seen this extraordinary life of lizards and cavemen and other forms of spokespeople for Berkshire’s GEICO division and they cost a lot of money. His advertising budget went from $30 million to $950 million over those years. And yet the number of insured went from two million to 10 and with $1500 NPV for every new insured customer the value was around $15 billion. Berkshire did that in part because they were permitted to suffer the report the losses of the first year of and celebrate the NPV gains that they picked up. That is one example how Berkshire showed the value of this approach.

In the table below, I have visualized the two scenarios that Geico faces when deciding whether or not to acquire an additional policy holder. The short-term effect is an expense of $250, that will lower reported earnings for the fiscal year in wich the policy holder is aquired. The short-term impact is negative when looking at the accounting profit for the year. But, the long-term effect is just the opposite, since in this case adding a new policy holder results in a net present value (NPV) of $1,500, i.e. the economic profit that adds to Geico’s intrinsic value.

G1

First-Level vs. Second-Level Thinking

When I read the text above about the short-term P&L impact from acquiring a new policy holder, versus the long-run value creation that adds to the business’s intrinsic value, I came to think of Howard Marks and his mental models first- and second-level thinking. It looks like the Geico acquisition case above fits right into these models.

Let’s refresh our minds, and start with Howard Marks description, from his book The Most Important Thing, about what separates first-level thinking from second-level thinking.

Howard Marks answers the question “What is second-level thinking?” by giving a few examples, among them this one:

• First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.”

Marks then goes on to explain the two different ways of thinking.

First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.”

Second-level thinking is deep, complex and convoluted. The second-
level thinker takes a great many things into account:

• What is the range of likely future outcomes?
• Which outcome do I think will occur?
• What’s the probability I’m right?
• What does the consensus think?
• How does my expectation differ from the consensus?
• How does the current price for the asset comport with the consensus view of the future, and with mine?
• Is the consensus psychology that’s incorporated in the price too bullish or bearish?
• What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

Geico: From a Second-Level Thinking Perspective

From the Geico policy holder acquisition case above, we could formulate our own rules as:

• First-level thinking says, “The company’s earnings will fall; don’t acquire any/or too many new policy holders in a certain fiscal year.” Second-level thinking says, “NPV for each new policy holder signed up is $1,500; acquire additional policy holders as long as the NPV for every new policy holder is positive.”

Let’s end this post with another Buffett quote worth remembering.

“Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable.” —Warren Buffett

References

What GEICO’s Customer Acquisition and Associated Costs Taught Me about Business Economics, Management Quality, and Valuation (by Sanjay Bakshi)

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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.

BRKBBV1

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.”

[…]

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.

************

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. 

[…]

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)

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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. 

Berkshire Hathaway Value Update, Year-End 2014

“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). In our 2010 annual report, however, we laid out the three elements – one of them qualitative – that we believe are the keys to a sensible estimate of Berkshire’s intrinsic value. That discussion is reproduced in full on pages 123-124.

Here is an update of the two quantitative factors: In 2014 our per-share investments increased 8.4% to $140,123, and our earnings from businesses other than insurance and investments increased 19% to $10,847 per share.”

—Berkshire Hathaway, Annual Report 2014, p. 7

Intrinsic Business Value Update

Last weekend I read the 2014 annual report from Berkshire Hathaway. As usual I enjoyed it, and even more so this year due to the extra writings from both Warren and Charlie.

Buffett himself summed up Berkshire’s 2014 in a good way in the beginning of the shareholder letter, when he said that “It was a good year for Berkshire on all major fronts, except one.” The exception was attributable to BNSF that according to Buffett “…disappointed many of its customers. These shippers depend on us, and service failures can badly hurt their businesses.”

The table below shows some key financial data for the prior ten-year period, including an estimate of intrinsic business value (by using the so-called “two-bucket approach”).

By using this two-bucket approach and applying a pre-tax earnings per share multiple of 10 times, results in a intrinsic business value per A share of $248,593 (or $166 per B share) at the end of 2014, and increase of 12.8% year-over-year. Book value per share increased 8.3%, from $134,973 to $146,186. The biggest change was in the price per share, increasing 27.0% year-over-year, from $177,900 to $226,000.

BRKA2014_1

The 10-year average intrinsic business value (IBV) to book value (BV) was 1.65. Price to book value and price to intrinsic business value averaged 1.38 and 0.84 respectively.

BRKA2014

At the moment (March 6, 2015) the A share is trading at $218,986 (or $146 per B share), giving a margin of safety of 12%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

TBR: Kopparberg Brewery

Kopparberg Brewery: Company Information

Kopparberg Brewery is a family run business, owned and managed by the Bronsman brothers, Peter and Dan-Anders. The brewery still stands on the original site where it was built over 130 years ago. Generations of local families have worked for Kopparberg over the years and to this day it remains the main source of employment for the town’s 4,000 people. The town itself is located in central Sweden, just over a two-hour drive from Stockholm.

Kopparberg Brewery was re-established in 1994, when Peter Bronsman and his brother Dan-Anders Bronsman bought the old brewery in the town of Kopparberg, Sweden. 36 regional brewers originally founded it in 1882. Kopparberg is now sold in more than 30 countries and is the world’s best-selling pear cider. Kopparberg is listed in Sweden on the NGM Nordic MTF. (Source: Kopparberg Company Presentation 2014)

K2_1Revenues, Products and Markets

Kopparberg has shown a rapid growth during the last 20 years. Revenues grew from 46 MSEK in 1994/95 to 2 403 MSEK in 2013, a compounded annual growth (CAGR) rate of 21.9%. Click image below to enlarge. The CAGR in revenues between 2004-2013 was 10.2%.

K3

Revenue Breakdown 2013 (SEK, million)
Sweden 549.8 34.2%
EU 991.1 61.6%
Rest of the World 68.5 4.3%
1,609.4 100.0%

The annual report for 2013 (see here for annual report in Swedish, there is no English version) does not provide a breakdown of revenues per product line.

Kopparberg’s products at the moment are (Source: Kopparberg Company Presentation 2014):

  • Kopparberg Premium Cider
  • Sofiero (beer)
  • Zeunert’s Premium Beer
  • Fagerhult Export (beer)
  • Dufvemåla (bottled water)
  • Gammaldags Svagdricka
  • Frank’s Vodka
  • Richard’s Dry Gin

K1According the Kopparberg itself:

  • Kopparberg Cider is the best selling Pear Cider in the world.
  • Sofiero Original is the best selling beer for the 11th year running at Systembolaget (the Swedish monopolist).

One third of the revenues (549.8 MSEK) comes from Sweden, sales in EU make up about 62% and about 4% comes from sales in the rest of the world.

Return on Capital: Magic Formula

Amounts in SEK millions.
Fiscal year 2013.
Kopparbergs
(KOBR MTF B)
Return on Capital 33.5%
EBIT 129.
Net Fixed Assets 404.0
Net Working Capital -19.0
Current Assets 758.0
Current Liabilities 776.0
Excess Cash (>5%) 0.0
Drivers of Return on Capital
EBIT-margin, % 8.0%
× Invested Capital, turns 4.2
= Return on Capital 33.5%
Earnings Yield 7.6%
EBIT 129.0
Enterprise Value 1,696.0
   Market Capitalization 1,432.0
   Debt 263.0
   Excess Cash 0.0

See graph below for a comparison of return on capital and return on equity.

KD2Profitability, Book Value and Dividend

Profit margins have improved during the last ten years, see graph below.

KD3Book value per share has shown a CAGR of 10.4%, amounting to 5.04 SEK in 2004 compared to 12.60 SEK in 2013.

Dividend per share was 1.90 SEK in 2013 compared to 0.15 SEK in 2004, a CAGR of 32.6%. The payout ratio in 2013 was 54.9%, compared to a ten-year average of 53.8%.

KD4Earnings & Cash Flow

Net income grew from 5.7 MSEK 2004 to 71.3 MSEK in 2013, a compounded annual growth (CAGR) rate of 32.5%. Earnings per share (no dilution) in 2013 was 3.46 SEK, compared to 0.27 SEK in 2004, a CAGR of 32.5%.

Free cash flow grew from 18.0 MSEK 2004 to 61.9 MSEK in 2013, a compounded annual growth (CAGR) rate of 14.7%. Free cash flow per share (no dilution) in 2013 was 3.00 SEK, compared to 0.87 SEK in 2004, a CAGR of 14.7%. During the last ten years Kopparberg has invested a lot in capital expenditures to support the revenue growth.

KD1Trailing twelve months (TTM) earnings per share was 3.89 SEK.

Valuation: Quick & Dirty

If we assume an earning power between 3 to 4 SEK per share together with an earnings multiplier range of 15 to 25 times, we get a range of intrinsic business value per share of 45-100 SEK.

Intrinsic Business Value per Share Range
Earning Power 15x 20x 25x
3 SEK/share 45 60 75
4 SEK/share 60 80 100
Price per share 70
Low end High End
Margin of safety -35,7% 14,3%

For the time being, until further research has been done, let’s say a reasonable earning power equals the TTM EPS of 3.89 SEK, and an earnings multiplier of 20 times to be a fair one. This gives an intrinsic value of 77.8 SEK.

Kopparberg will be added to the watch list.

To be researched (TBR)

Some things, among others, to be further researched are:

  • Revenues per product line
  • Competitors and industry characteristics
  • Business risks
  • Capital expenditures
  • Cost structure
  • Financial leverage

Disclosure: 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 or individual mentioned in this article. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Lundbergs

Lundbergs: A Swedish Investment Company

LLogo1

Lundbergs (STO:LUND-B) is an investment company that manages and develops a number of companies based on active, long-term ownership.

The asset portfolio includes:

  • The wholly owned real estate company Fastighets AB LE Lundberg
  • The publicly traded subsidiaries Hufvudstaden and Holmen
  • The associated companies Indutrade and Husqvarna
  • Lundbergs also has major shareholdings in Industrivärden, Handelsbanken, Sandvik and Skanska

Lundbergs’ objective is to generate a return on invested capital over time that substantially exceeds the yield on a risk-free interest-bearing investment.

L3Lundbergs’ History

Since this is the first time that I look at Lundbergs, I have included their own text about their history (Source: Lundbergs).

In 1944, when Lars Erik Lundberg was only 24, he formed the company that was later to become Lundbergs in his apartment in Norrköping. This company engaged in construction operations and focused on residential building. From an early stage, Lars Erik aimed to master the entire building process from land acquisition to finished product, a full-service construction business.

Geographically, business activities were established in many locations throughout central and southern Sweden in the 1950s and 1960s. During the same period, the construction operations also expanded to include office buildings and department stores.

At an early stage, Lars Erik Lundberg started to show an interest in investing in proprietary properties, having understood the value represented by expansion into an additional business sector, real estate management. This move created greater stability in the Company, which could gradually reduce its dependence on construction operations. It is this foundation upon which Fastighets AB L E Lundberg’s property operations rest today. Since the end of the 1950s, the property holdings have grown successively, and now consist almost entirely of proprietary properties. Apart from residential properties, the holdings also include commercial properties for retail activities and offices.

At the end of the 1970s, Lundbergs began to consider a further expansion of the Group’s operations and, during the 1980s, a series of investments were made within new industries. Finance companies were acquired and developed, as were several smaller industrial companies. Investments were also made in certain publicly listed companies, which gradually resulted in several major shareholdings in such companies as Incentive, Holmens Bruk, Alfa Laval, Siab and Östgöta Enskilda Bank. The Group’s operations became increasingly diversified and, during the second half of the 1980s, it was decided that investments outside the core area of construction and real estate operations would be concentrated in a limited number of publicly listed companies. Other operations were divested and, in the early 1990s, major shareholdings in Alfa Laval and Incentive were sold to Tetra Pak and ASEA, respectively. These structural transactions meant that significant capital was released, thus strengthening the capital base considerably.

In 1983, the shares in Lundbergs, with Fredrik Lundberg as President, were listed on the Stockholm Stock Exchange. From its original status as a wholly owned family company, the step was now fully taken into the glare of the public eye. However, the Lundberg family retained a clear majority holding in the Company.

At the beginning of the 1990s, Sweden was afflicted by what was commonly called the finance crisis. As the principal owner of Östgöta Enskilda Bank, Lundbergs was hit heavily by this crisis. However, the bank was saved as a result of very substantial capital investments from Lundbergs. In 1997, the Östgöta Enskilda Bank was sold to Danske Bank at a healthy gain.

In 1994, the construction operations were transferred to the associated company Siab, which merged with NCC in 1997. During the 1990s and to date in the 2000s, substantial investments have been made and Lundbergs has become the principal owner of Holmen and Hufvudstaden. Lundbergs has also been the principal owner of Cardo since 1998. All of the holdings were divested in March 2011. Lundbergs also has major shareholdings in Handelsbanken, Husqvarna, Industrivärden, Indutrade and Sandvik.

Accordingly, during its first 65 years, Lundbergs has developed from a construction company to an investment company with interests in several different areas.

Ownership

Fredrik Lundberg is the largest owner of Lundbergs with a share capital of 54.6% and voting rights of 89.9%. Together with his wife, Anne-Marie Lundberg, and his daughters, Louise Lindh and Karina Martinson, he controls 69.6% of the share capital and 93.4% of the voting rights.

L8Dividends and Book Value

Dividend per share in 2013 was 4.60 SEK, compared to 4.30 SEK in 2012. Dividend yield was 1.7% at year-end 2013, and 1.9% in 2012. See image below for historical development. L11Net asset value at year-end 2013 and 2012 was 42,771 and 37,501 million SEK respectively, or 345 and 302 SEK per share. See image below for historical development. L12Lundbergs Net Asset Value

Lundbergs owns shares in the following Swedish listed companies:

  • Handelsbanken (Bank)
  • Holmen (Paper & Paper Products)
  • Hufvudstaden (Real Estate)
  • Husqvarna (Tools & Accessories)
  • Industrivärlden (Investment Company)
  • Industrade (Industrial Distribution)
  • Skanska (Engineering & Construction)

Lundbergs also owns 100% of Fastighets AB Lundbergs, a real estate company.

Click image below to increase the size (Source: Lundbergs, Q2 2014).

As of June 30, 2014 Lundbergs net asset value after deferred tax was 46.6 billion SEK, or 376 SEK per share, an increase of 9.0% compared to December 31, 2013, and a net asset value of 24.8 billion SEK, or 345 SEK per share.

The table shows that stocks in Holmen, Hufvudstaden, Industrivärlden and Handelsbanken make up 57% of the total stock portfolio. No single investment is below 5% of the portfolio, except for the Other shares category.

L10 Look-Through Earnings

In the table below I have tried to estimate a reasonable earning power for each individual holding in the stock portfolio, and for the wholly-owned real estate business Fastighets AB L E Lundbergs.

The estimate of earning power is a rough guess of what I think might be considered reasonable. The assessment is based on earnings data from the annual reports filed by those companies.

Company Share Capital Voting Rights Earning Power* Lundbergs’ Share*
June 30, 2014 [2] [1]×[2]
[1]
Industrivärlden 11,6% 17,5% 3 830 444
Hufvudstaden 45,3% 88,1% 850 385
Fastighets AB
L E Lundberg
100,0% 100,0% 400 400
Handelsbanken 2,0% 2,0%** 13 500 211
Holmen 32,9% 61,6% 800 263
Skanska 3,9% 11,9% 4 500 176
Indutrade 23,8% 23,8% 550 131
Sandvik 2,4% 2,4%** 6 500 122
Husqvarna 7,6% 23,6% 1100 84
Admin. aft. tax -23,4*** -23,4
Earning Power, total: 2 191
Earning Power per Share: 17,7
Earnings Multiplier, 15 times 265,1
Price per Share: 291,2
Earnings Yield, %: 6,1%
Margin of Safety -9,0%

*Amounts in million SEK except per share data.
**Taxable for Lundbergs. Amount reduced with current tax rate of 22.0%.
***Amount of 30 million SEK for personnel expense and other, reduced with 22.0% for taxes. Taken from the FY2013 parent company financial statement.

From the table above and the estimated earning power of each business, the composition of earnings is shown in the chart below. Top three and five investments make up about 55% and 77% respectively of the total.

LEC1From the calculation in the table above we see that Lundbergs’ earning power per share is about 17.7 SEK per share. Applying an earnings multiplier of 15 times gives an intrinsic business value per share of 265 SEK, compared to price per share of 291 SEK, and thus a negative margin of safety of 9%.

Lundbergs will be added to the watch list.

Disclosure: 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 or individual mentioned in this article. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Berkshire Hathaway: Intrinsic Value (Part 4)

BRKLogo

A last look at Berkshire’s intrinsic value

From earlier post, part 1 to 3, the following values for the Berkshire A-share have been calculated:

  • Post 1: Book value per share – $138,426 (as of Q1 2014)
  • Post 2: Adjusted book value per share – $205,604 (as of Q1 2014)
  • Post 3: Two-bucket approach – $220,413 (as of Q4 2014)

See chart below for a summary of historical values for the three different metrics above.

BVPS8

From the calculations in earlier posts an intrinsic value in the range of $200,000 to $225,000 seems reasonable.

Price per A-share as of today is approximately $191,750, implying a margin of safety in the range of 4%-17% depending of where in the value range you look. A fair price, but not a bargain at the moment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Berkshire Hathaway: Intrinsic Value (Part 3)

BRKLogo

The two-bucket approach to valuing Berkshire

In his 2008 letter to shareholders Buffett discussed the yardsticks for measuring the value of Berkshire as follows.

“Berkshire has two major areas of value. The first is our investments: stocks, bonds and cash equivalents. At year-end those totaled $122 billion (not counting the investments held by our finance and utility operations, which we assign to our second bucket of value). About $58.5 billion of that total is funded by our insurance float.

Berkshire’s second component of value is earnings that come from sources other than investments and insurance. These earnings are delivered by our 67 non-insurance companies, itemized on page 96. We exclude our insurance earnings from this calculation because the value of our insurance operation comes from the investable funds it generates, and we have already included this factor in our first bucket.”

The two-bucket approach: Intrinsic value per share

In the table below I have taken the pre-tax earnings per A-share (EPS) together with an earnings multiplier of 10. Assuming a 35% tax rate, this equals an after-tax earnings multiplier of approximately 15 times (10/(1-0,35)=15.4), which seems reasonable.

To the 10 times earnings per share I have added per-share investments, to arrive at an estimate of intrinsic value per A-share. This is what Warren refers to as the so-called two-bucket approach.

From these calculations, see table, we get an intrinsic value in 2003 of $90,033 compared to $220,413 in 2013, an increase of 144.8%, equal to a compounded annual growth rate of 9.4%.

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Intrinsic value has grown steadily, only decreasing year over year in 2008.

The highest margin of safety seems to have existed in 2011 and 2012, after the financial crisis.  Even if there still seems to be some margin left, calculated from the intrinsic value of 2013 ($220,413) compared to the share price at the end of March 2014 ($187,350), the margin today has decreased to approximately 18%.

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In the next post I will summarize the main points from the three post so far about the different ways to value Berkshire. 

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Berkshire Hathaway: Intrinsic Value (Part 2)

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Adjusted book value per share

In this post I will take a look at two balance sheet items on the liabilities side, and adjust the reported book value figure for float (a liability or “Money we hold but don’t own” as Warren explained in the shareholder letter in 1997) and the deferred tax liability. This will result in an adjusted book value per share, that can be compared to book value per share as reported in Berkshire’s financial reports, and also to the market price per share.

Before getting into the adjustments I have inserted a few quotes below from Warren to give some context, and also to provide some reasoning for the adjustments that will be done to book value.

Book value far understated intrinsic value

“Book value far understates Berkshire’s intrinsic value, a point true because many of the businesses we control are worth much more than their carrying value. Inadequate though they are in telling the story, 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. In other words, the percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value.” ― Warren Buffett, Owner’s Manual

Deferred tax assets and float: The benefit of debt

“Of course, we ourselves will periodically have a terrible year in insurance. But, overall, I expect us to average an underwriting profit. If so, we will be using free funds of large size for the indefinite future.”  Warren Buffett, Letter to Shareholders 2008 

“Besides, Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and “float,” the funds of others that our insurance business holds because it receives premiums before needing to pay out losses. Both of these funding sources have grown rapidly and now total about $135 billion. Better yet, this funding to date has often been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt – an ability to have more assets working for us – but saddle us with none of its drawbacks.”  Warren Buffett, Owner’s Manual

Adjustments made and some explanations behind them

  • Reported book value per A-share has been taken from the annual reports of Berkshire, except for the quarter ending in March 2014 that has been taken from the first quarterly report of 2014.
  • Assuming that the insurance business as a whole runs an underwriting profit on average means that the cost of funding the float is zero or negative. If this is the case the economic value of float is zero, i.e., no liability. From this, a conservative estimate that looks reasonable would be to add back 80% of this float liability. Adding back 100% at the end of Q1 2014, would increase the adjusted book value per A-share by approximately $9,500.
  • Deferred tax liabilities, most of them related to unrealized profits on investments that won’t be paid until realized. Depending on how long, also an interest-free loan that is dependent on when it will be repaid. Assuming that Berkshire will hold on to its investments for the long run, with some divestments expected to take place during the coming years, adding back 80% of the deferred tax liabilities looks like a reasonable assumption. Adding back 100% at the end of Q1 2014, would increase the adjusted book value per A-share value by approximately $7,300.

See graph below for an comparison of this adjusted book value, as described above, to the market price for the last ten years. Historical prices for Berkshire’s A-share (NYSE:BRK.A) has been taken from Google Finance.

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The table below shows the adjustments made to book value, with all numbers being stated as per share of A-shares. Click on images to view larger versions.

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Some concluding thoughts: Book values so far

Adjusted book value per A-share from the above table amounts to $205,604 ($137 for B-shares)at the end of March 2014, compared to $187,350, giving a margin of safety of 9.7%.

Summarizing the different values so far, from this post and the earlier one, we get some interesting amounts.

Abbreviations used in the table are:

  • BV, % = Cell X / Book Value
  • MP, % = Cell X / Market Price
  • MoS = MP,% – 1

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In the next post I will look at intrinsic value from the so-called two-bucket approach that derives the value from per-share investments and value of non-insurance businesses.

Looking at the end of the first quarter 2014, there still was some room for the market price to catch up to the estimated adjusted book value. At the same time the margin of safety was 9.7%, the lowest since year-end of 2011.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Berkshire Hathaway: Intrinsic Value (Part 1)

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Intrinsic value of Berkshire Hathaway – Today and Tomorrow

I thought I would take a look at Berkshire Hathaway and its intrinsic value to be able to compare it to the current stock price to see if there is any difference between them. The analysis of Berkshire’s intrinsic value will be divided into the following three parts:

  • Book value per share
  • Adjusted book value per share
  • Two-bucket approach

Book value per share

Warren has many times emphasized the change in book value as a proxy for the change in intrinsic value. For example, in his letter to shareholders in 2012 Warren wrote that “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.”

So, if this holds true, i.e., that book value is a significantly understated proxy of intrinsic business value, we can look to the change in book value to try to get a sense of the possible change in intrinsic value. From Berkshire Hathaway’s officially published annual reports – you find them here – book value per share in the last 10 years has been as follows in the table below. Percentage shows the change in book value per share from year to year.

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Book value per share in 2003 was $50 498 compared to $134 973 at year-end 2013, a gain of 167.3% or a 10-year compounded annual growth rate of 10.3%.

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Book value per share can be seen as another measure for a conservative estimate of intrinsic value. Remember this, and the words “a conservative one.” In the shareholder letter from 2012 Warren wrote that “The value of our float is one reason – a huge reason – why we believe Berkshire’s intrinsic business value substantially exceeds its book value.”

Book value per share at the end of the first quarter 2014 was $138,426.

This seems like a conservative measure, considering the fact that Warren is willing to buy back stock at prices of 120% of book value. Calculated from the $138,426 at the end of the first quarter 2014 120% gives a target buy back price level per share of $166,111.2.

Current stock price

Right now Berkshire, according to Google Finance, is trading at a price per share of $189,724.

Currently the Berkshire stock trades at a price to book multiple of 1.37, i.e., the stock price exceeds book value per share with 37% at the moment.

Compared to the 120% above book value where Warren is ready to buy back Berkshire stock, the current stock price is exceeding this target level with 14.2%.

Looking at the downside the current stock price would have to drop with 12.4% before Warren steps in and starts to buy back Berkshire stocks. In other words, there seems to be a pretty good downside protection at the moment.

Having looked at the book value per share and the downside scenario, in the next post I will take a look at an adjusted book value per share.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.