What asset would you prefer to own? BRK or zero coupon US treasuries? (I use zero coupon US treasuries as BRK does not pay a dividend.) I consider BRK to be a better credit than the US government, while I can't think of other companies that are. Well, I feel I am pointing out the obvious... but that, the safe part, is actually why I like this investment so much. I am getting a growing asset with a 40% plus upside where I have minimal risk of permanent loss of capital. I like investments where I don't have to think very hard and BRK at this price seems to be one of those ideas. (Btw. 10 year zero coupon bonds yield 3.56%, significantly lower than BRK's long-term growing earnings power.)

I am valuing BRK based on what I think it should be worth on December 31, 2012. A 20 month holding period seems to be a reasonable holding period for its price to adjust to intrinsic value.

I believe BRK will be worth $125.05 per B share by the end of 2012, providing an intrinsic value about 47% higher than the current stock price. I value BRK as the sum of the IV of the operating businesses using normalized earnings, the current value of the cash, bonds and stocks and the expected earnings stream through Dec 2012.

Value of the operating businesses per share.

Start with the December 31, 2010 BRK Pre -Tax Normalized Earnings of $17 billion.

I was quite intrigued when WEB decided to list his normalized earnings power, ex cat events. He just made things a lot easier for all of us. So I start with the $17 billion number. One adjustment one could make is related to the cat events. First I thought of taking down the $17 billion by $1 billion for cat events. But on the other hand I think WEB does not include the underwriting results in the $17 billion. So as BRK's average combined tends to be below 100 in the long term, I think it is correct to offset the long-term cat losses by the long-term underwriting profits and use the $17 billion.

In order to get to the normalized earnings for the operating businesses I exclude the investment income.

The investment income for 2010 was $5.1 billion. WEB mentioned that the normalized earnings did not include the GE, GS and Swiss RE investments which collectively provided $1.16 billion in interest income in 2010. WEB then also mentioned he included $500 million in expected interest on cash and expected higher dividend for WFC and other public stock holdings. For WFC I took $340 million and for the rest of the stocks I added $150 million in dividends. I know I am aggressive regarding the WFC dividend, but as the more conservative scenario it made sense to me to use $340 million. This gives me a normalized investment income of $4.93 billion.

$17 - ($5.1 - $1.16 + $0.5 + $0.34 + $0.15) = $12.07 billion in December 31, 2010 pre tax normalized earnings ex income from investments.

Then we adjust for the Lubrizol impact.

Lubrizol was purchased for $9.7 billion. I am assuming WEB wants at least a 10% pre tax normalized income which makes $0.97 billion in normalized pre tax earnings. Adding that to the $12.07 billion in Dec 31, 2010 normalized pre tax earnings ex income from investments, gets me $13.04 billion in post Lubrizol pre tax normalized earnings ex income from investments.

$12.07 + $0.97 = $13.04 billion

I use a 30% tax rate.

Over the last few years, BRK's tax rate has been around 30% and in the normalized earnings calculation WEB uses a 30% tax rate too. A 30% tax rate gets me $9.13 billion in post tax post Lubrizol normalized earnings ex income from investments.

$13.04 * 0.7 = $9.13 billion.

Now I adjust for some growth potential

I assume it to be reasonable that the normalized earnings potential of the current operating businesses increases by about 5% a year. Making an adjustment for the 20 months until the end of 2012, I get a cumulative growth of 8.33% or $9.88 billion in post tax post Lubrizol Dec 2012 normalized earnings ex income from investments.

$9.13 * 5% * (20/12) = $9.88 billion.

A 5% annual growth rate?

o       Why only 5%, especially since the total earnings of the operating businesses has grown faster over the years? I am only looking at the current normalized earnings of the current businesses owned. A big reason why BRK's earnings from operating businesses has grown so fast is that new businesses have been added over time. In order to add more businesses WEB needs cash. That cash is currently included in my valuation as part of the investment assets, the sum of cash, bonds and stocks. If I would add growth from earnings from businesses not yet purchased, I would be double counting.

o       Why the 5%? Well 5% seems to be a conservative, but still reasonable number. I do believe that the BRK operating businesses have an operating advantage in that they can focus solely on building the business long-term, rather than having to deal with the "beating the quarterly earnings crowd", which I believe to be a meaningful differentiator.

I use a 15 multiple for the operating businesses per B share.

So the $9.88 billion in post tax post Lubrizol 2012 normalized earnings ex income from investments translates to $4.00 post tax post Lubrizol 2012 normalized earnings ex income from investments per B share.

In the past WEB has directed towards a 12 pre tax multiple, which at a 30% tax rate comes to a post tax multiple of 17.14. To be more conservative I use a multiple of 15 times. 15 times $4.00 gets me $60.00 in IV per B share.

Value of the investments (Cash, Bonds, Stocks)

$155.86 billion in investments

On Dec 31, 2010 BRK had about $155.86 billion in investments. There is not much to add when it comes to the cash and fixed income portfolios, but I do believe the portfolio of stocks seems somewhat cheap. I can't add much when it comes to BYD, Tesco and Sanofi. But if you look at the rest of the stocks, AXP, JNJ, KFT, Munich Re, POSCO, WMT, USB and especially WFC, all seem cheap. P&G and KO seem reasonably priced. My conclusion is that the intrinsic value of the investments is probably higher than the current $155.86 billion.

So what if we enter another bear market and stocks sell off as well as a period where interest rates spike and bonds sell off? For one it would be great as WEB would be able to allocate cash towards buying cheaper assets, but also I really only care about the IV of those investments not their short-term price volatility. The portfolio of assets getting cheaper does not mean its intrinsic value declines at the same time.

Should I adjust for deferred taxes?

I know the deferred tax issue is somewhat controversial. BRK had about 27.8 billion on Dec 31, 2010 in gains on its book of stocks. If we pay a 40% tax rate, that gets us a tax payment upon sale of $11.12 billion. On the other hand, almost all the gains, $24.4 billion, are related to AXP, KO, PG and WFC, all companies that are unlikely to be sold. There is a (small) chance that some sale might happen, but it is unlikely that all will be sold. So it seems reasonable to me to take half of the $11.12 billion in deferred tax liability which equals $5.56 billion and deduct that from the $155.86 billion in investments for a total of $150.3 billion in investments.

Should I adjust for the float?

Well, that is also a controversial issue. I am on the side of not adjusting for float. My reasoning is that if I give you the full usage rights to an asset for a very long time at no cost, then in practical terms you become the owner. Here is an example, I do not own the parking space at my house, but I have been granted the perpetual usage rights at no cost, so in practical terms I am the owner of that parking space. In the case of the float, if someone lends me an amount of money on a perpetual basis at no cost, then in practical terms I become the owner of that money. The other reason is that WEB has laid out a number of times that he considers his float to be permanent zero cost capital and thus thinks of it as equity. (I know I defer to WEB, but the way I look at it is why try playing Michael Jordan at basketball if he offers to join your team.)

Adjustments for Lubrizol, the prepayment penalty related to GS, GE and Swiss Re and 2011 interest payments GS and GE.

I deduct $9.7 billion from the $150.30 billion (post deferred tax payment assets) to compensate for the post Dec 31, 2010 purchase of Lubrizol. I add the $1.4 billion in pre-payment penalty after tax related to the post Dec 31, 2010 repayments made by GS, GE and Swiss Re (I assume GE will redeem to in 2011) and lastly I add one quarter of interest after tax for GS and 3 quarters after tax for GE as GE can only redeem post September 2011.

$150.30 - $9.70 + $0.84 + $0.08 + $0.14 = $141.65 billion in investments or $57.41 per B share. The $0.84 is the pre payment penalty of $1.4 billion after tax. The $0.08 is the Q1 interest payment for GS after tax. The $0.14 is the Q1, Q2 and Q3 interest payments for GE after tax.

Adding the earnings through Dec 31, 2012.

I start with the $17 billion in pre tax annual normalized earnings. From that I deduct the $500 million WEB expects at some time to earn on his cash, but short-term interest rates might stay low so I keep it out. In addition I also deduct $300 million in the dividend adjustments WEB mentioned as the dividend increases aren't all going to be realized within the next 20 months. Adjusted for the 20 months that gets me a pre tax normalized earnings though Dec 31 2012 of $27.00 billion. After tax that makes $18.90 billion or $7.65 per share.

I did not adjust for depreciation and capex. The reason is that when I am dealing with great capital allocators, I do not punish them by deducting growth capex from the depreciation number. And in a company this large and diverse, depreciation and maintenance capex will come close to balancing each other out. I know there is an inflation impact, but on the other hand much of that inflation impact often is cancelled out by productivity improvements.

($17 - $0.8) * (20/12) * (1-30%) = $18.90 billion or $7.65 per B share.

Intrinsic Value

The sum of the operating businesses, investment per share and earnings through Dec 2012 is $125.05. ($60.00 + $57.40 + $7.65), a 47% upside from the current price.

This intrinsic value does not include the potential impact from WEB's future capital allocation decisions, potential underwriting profits and a soft insurance market turning hard. All three are free options that are valuable.

Derivatives

The high yield exposure is pretty much behind us. There is still exposure of equity puts. The current liabilities at current exchange rates are $3.8 billion. The premiums received until now on the equity puts are $4.2 billion. Remember, these equity puts can only be exercised from 2018 through 2026. For those that are worried about this exposure I offer up the following:

o       WEB stated in his letter that while the overall number of contracts has gone down he has added a few new exposures. So even after the financial crisis he still feels comfortable with the exposure.

o       But just to be conservative ... What happens if things go wrong again? We have $0.4 billion in excess premium over liabilities. $4.2 billion in received premium is available for investments for periods from 7 to 15 years. If I take an average duration of the contracts of 10 years and compound at 7%, I get a double. It seems we have some wiggle room, but lets say things get worse again quick. Well, every $5 billion in losses represents $2.02 in assets per B share pre tax or $1.21 in assets per B share post a 40% tax. Lets assume now that BRK takes a $20 billion hit tomorrow on these puts and has to realize that loss at the same time. In that case, the cost would represent $4.84 per B share after tax. I'd rather not see that happen, but with an intrinsic value of $125.05 it would not be a disaster.

What about WEB becoming incapacitated?

Yes, it is clearly an issue, but it does not bother me much for the following reasons:

o       I am just valuing the current operating businesses. I took the normalized earnings of the current operating businesses, grew that at 5% which seems reasonable and put a reasonable multiple on it. I did not include a scenario where WEB would take lets say $20 billion, allocate it to a new acquisition at high rates of return and increase normalized income that way. In essence, in this scenario my BRK valuation treats WEB's future capital allocation decisions as a free option. Not including WEB's future capital allocation decisions in the valuation mitigates WEB's incapacitation in a big way.

o       It is not as if BRK will fall apart if WEB becomes incapacitated. A. There is a strong corporate culture that permeates the whole company, from the board on down. B. WEB is not very involved in the daily operations of the business. So there should be little direct impact on daily operations of the operating businesses.

What about the "why not buy the day when WEB becomes incapacitated" argument? First, how does one know the stock will sell off big and for long enough so one can buy? For a massive sell off to take place we must assume that the current owners haven't noticed that WEB is 80 years old by now. The succession story is well publicized and current owners do understand that at some point WEB will not be around. So if we know that, why would we sell en masse when it happens? And what if it means buying BRK at $140 after it falls from $160 when the stock can currently be bought for $85? The only reason why one shouldn't own BRK is because one has better alternatives. Not buying BRK or waiting for WEB to pass away while the company is cheap, even when one treats WEB's capital allocation skills as a free option, makes little sense to me. Third, might it be possible that there is another scenario, where WEB decides to fade out of BRK. A scenario where he appoints the people to run the company, slowly handing over responsibility. The assumption seems to always be that it will be all or nothing, one day he is here and the next day he will be gone.

So what will happen to all that cash if WEB is not around anymore? Well we have a great board and nothing prevents the board from handing it back to shareholders. Also senior management and the board, although not as talented as WEB, should be able to find opportunities to invest in. Senior management and the board might not as good as WEB, but they are sure better than almost all other boards and managements out there.

Risks

o       The economy.

o       WEB becomes incapacitated and the board botches the transition or changes the corporate culture.

Options

If you want to be more adventurous this might also work for you. A few days ago when BRK was trading in the $82s, one could sell the Jan 2013 $70 puts and buy the Jan 2013 $95 calls for little more than a $1 debit. Normally I would not like one of these spreads, but I felt comfortable in this case. I would gladly buy BRK at $70 and it seemed like a reasonable outcome for BRK to sell for more than $100 per B share before Jan 2013, which would multiply your investment. The problem is that there isn't a lot of liquidity in the options. Anyway, just thought of bringing it up. The stock price increased so the spread has widened, but maybe the stock comes down again.