At its present price of $83,900, Berkshire Hathaway is trading at one of the widest discounts to intrinsic value in recent years. The risk/reward equation with Berkshire is compelling.
What is Berkshire’s Intrinsic Value?
There are many different approaches one can take to arrive at Berkshire’s ballpark intrinsic value. Here is the approach I favor:
A. Operating Businesses:
A1. Mid-American Energy’s earnings and interest paid to Berkshire was $237 Million in 2004. There was a one-time writeoff in 2004 of $579 Million for an ill-fated Zinc recovery project. Excluding this, net after-tax earnings to Berkshire from MAE in 2004 would have been $530 Million (approx.). Assume this grows modestly to $600 Million in 2-3 years. Its likely to do a lot better – given all of Buffett’s comments on this business.
A2. Berkshire’s historical cost of insurance float has, on average, been negative. In 2004 float was $46 Billion with an underwriting profit of $1.5 Billion or 3.2%. Float has grown considerably since 2000 when it was $28 Billion. Note that the 2000 float number includes Gen Re. So Berkshire has grown float by 65% in 4 years organically or about 13% annually. Let us assume that float grows moderately in the future and average underwriting profit (now that all units are fixed and firing on all cylinders) is about $1 Billion or under 2% in a few years.
A3. The “Finance and Finance Products” category generated $2.3 Billion in pretax earnings in 2004 and $1.8 Billion in 2003. A large part of this is Buffett’s opportunistic trading operation – which may not be recurring. One could argue that Buffett consistently makes money with onetime bets – silver, junk bonds in 2002, Finova’s liquidation through Berkadia, AAA bond trades, Level 3 converts, currencies etc. So, let’s say Buffett generates, on average, $1 Billion per year through the potpourri of opportunistic trading that he’s so exceptionally good at. The rest of it (including Clayton Homes) should generate atleast $400 Million pretax. So $1.4 Million pre-tax – or about $1 Billion after-taxes.
A4. Manufacturing, Service & Retail Operations generated $2.5 Billion pre-tax and $1.5 Million after tax in 2004. Some of these businesses (like NetJets) are investing heavily in Europe for future growth. So, even modest organic growth should put earnings in this group around $2 Billion after-tax in 2-3 years.
In 2006-2007, these operating businesses (A1-A4) in total are likely to generate $4.6 Billion after taxes..
B. Investments. At the end of 2004, the public equities portfolio was valued at $38 Billion.
C. Cash and Bonds were $63 Billion at year end. Even at 2%, the cash alone is generating about $800 Million in Interest earnings annually. Charlie Munger has stated that their bond holdings are only there because of lack of interesting equities to put it in.
The company is generating about $1.2 Billion a quarter of cash. Over the next two years, cash is very likely to increase by $10 Billion. In addition, over the next 2 years float is likely to grow by atleast $5 Billion. So Cash and bonds at the end of 2006 is likely to be north of $78 Billion. Cash has been building for a while. It is likely that Buffett will get a chance to swing a few times in the next few years – perhaps deploying 1/3 to 1/2 of the $78 Billion war chest. If 40% is deployed at a modest 10% after-tax return, earnings would rise by $3 Billion.
Operating Earnings in this scenerio would be $7.6 Billion. At a 15x multiple this is worth $114 Billion. Assume just 5% annualized growth in value of the public equities would put them at $42 Billion. And finally there is the residual $48 Billion in cash and bonds. This aggregates to $204 Billion. With 1.538 Million shares outstanding, the IV per share is $132,600 per share in a couple of years. With a present price of $83,900, it is an annualized return of over 25%.
Buffett has mentioned that it is ok to consider float as equity for Berkshire when calculating intrinsic value since it has cost it nothing over the years, on average.
None of the aforementioned is aggressive. If equity markets drop significantly the results may be significantly better. And there is no assumption of stellar acquisitions – if he is able to buy businesses in distressed industries (like Clayton) and then add the Berkshire touch, its even better. There are many ways one can interpret the following statement from the 2004 Annual letter:
“Charlie and I will work to translate some of this hoard into more interesting assets during 2005, though we can’t promise success.”
Buffett mentioned to a group of students that he was trying to buy “a few billion” worth of a public company recently and today there was news of Berkshire’s new significant stake in Anheuser Busch. I think he has some irons in the fire already.
Some members will disagree with the assumptions. That’s fine. For example, you can assume a zero underwriting profit and reduce IV by $10,000. You can tweek the numbers to your liking and arrive at an intrinsic value you’re comfortable with. All the major factors that matter for BRK’s intrinsic value are presented here. Any of them can be edited to your heart’s content. My take is that I’m buying assets worth over 120K or $130K for under $84K and then letting the greatest capital allocator do his magic on those assets. There is significant upside here with virtually no downside.
Value is its own catalyst. Over time it will be appropriately weighed and valued with a good result for investors.