Berkshire Hathaway BRK.A
October 18, 2007 - 6:22pm EST by
flubber926
2007 2008
Price: 129,000.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in M): 199,600 P/FCF
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT

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Description

We believe the discount at which Berkshire Hathaway trades today versus its intrinsic value is as large as it has been in the past and only comparable to that which briefly existed in early 2000 and prompted Mr. Buffett to publicly state his intention of repurchasing Berkshire’s stock at that time.   

Berkshire was originally written-up at this forum by nish697 a couple of years ago.   At that time nish estimated that the company’s fair value would be close to $132,000 per-share 18 to 24 months out.  We now know, with the benefit of hindsight, that thanks to Berkshire’s managers’ great execution and to Mr. Buffett’s investment skills, the company’s intrinsic value by yearend 2006 was roughly in line with that which nish predicted would be.

It is our estimate that Berkshire’s fair value, after two continuous years of stellar results from its insurance division lies somewhere between $150,000 and $160,000 per-share at this time. Using very conservative assumptions and nothing more than sixth grade math, it is our estimation that by yearend 2008, Berkshire’s intrinsic value should approximate $200,000 per-share.

Berkshire’s growth in value has far outpaced the appreciation of its shares and although this has probably been the case for the last two years, we think that the divergence between value and price has never been as wide as it is today. Berkshire trades at what we believe are depressed prices and should return close to 55% within the next 12-18 months, if it reaches its fair value, with minimal downside risk.

Because I suspect this is a very well known company for most fellow members of this club, I will not waste your time with an introduction and concentrate instead on the company’s valuation, its growth history, touch upon what we believe are some of the key concerns weighing on investors today and finally discuss possible catalysts and potential risks to our thesis.

Without further due,


 

I.                    Valuation

 

Berkshire’s valuation at current prices ($129,000 per-share)

Although we recognize that there are different ways to get to Berkshire’s intrinsic value, we prefer to take a very simplistic approach which is to value its operating units, add the per-share value of the investments in publicly traded securities owned by the company and finally add any excess cash generated.
 
As of yearend 2006, Berkshire’s investments per-share were $80,636. Let’s assume a conservative 7% appreciation and by the end of 2008, investments per-share should be somewhere around $92,300.
 
Berkshire is generating around $ 9 billion of cash every year, let’s assume $ 18 billion of excess cash in two years or roughly $12,000 per-share excess cash by the end of 2008 versus 2006.              
 
 

Berkshire's share price

                       129,000

- Investments

                         92,300

- Excess cash

                         12,000

Value of operating businesses

                         24,700

2008E after-tax op. earnings

                          6,027

after-tax implied multiple

                              4.1

 

 

 

 
 
We are adjusting 2008 underwriting earnings downward because we believe that 2006 and 2007 underwriting results are not sustainable given the absence of any large super-cat event during both years.  If this continues to be the case for some years Berkshire’s earnings will be far larger than what we predict but we just can’t count on that happening.
 
Basically, at current prices you get Berkshire’s operating divisions (insurance, utilities, manufacturing, services, retailing), for 4 times after-tax 2008 normalized earnings. Essentially you are paying 4x for a collection of businesses that have been growing pre-tax earnings at a compounded rate of 31.7% for the last 10 years and have great prospects ahead of them.

 What is the normalized earnings power of Berkshire’s op. businesses?

2006

2005

2004

Insurance – underwriting

 $           2,485

 $              27

 $          1,008

Insurance - investment income

3,120

2,412

2,045

Utilities and energy

885

523

237

Manufacturing, service and retailing

2,131

1,646

1,540

Finance and financial products

732

514

373

Other

-47

-124

-154

Investment and derivative gains/losses

1,709

3,530

2,259

Net earnings

 $          11,015

 $          8,528

 $          7,308

 

 

 

 

 

 

 

 

i)                    Insurance – Underwriting

 
The absence of super-cat’s during 2006 combined with huge premiums after the losses brought by both Rita and Katrina contributed to last year’s extraordinary underwriting results.
 
This year will likely be the second stellar year in a row thanks to a so far very benign hurricane season and the absence of large super-cat’s as well.  It wouldn’t surprise me to see underwriting profits approach $ 3 bn this year.
 
However, as Mr. Buffett has repeatedly said, we just can’t count with such stellar results repeating themselves in the future.
 
As of yearend 2006, Berkshire’s float was $ 50.9 billion and if you add the retroactive reinsurance contract written with Equitas, which adds $ 7 billion, float should be around $ 59 to $60 billion as of today. We assume that float grows modestly to around $62 billion by yearend 2008 and that underwriting profit is a modest 3% or $ 1.86 billion that year. That is a 25% haircut from 2006 underwriting results which we believe is conservative enough.

 

ii)                   Insurance -  Investment Income

Investment income has grown at an after-tax rate of 23-25% during the last three or four years putting to rest all doubts on Mr. Buffett’s ability to invest Berkshire’s large sums of cash.
 
To be conservative, let’s assume only a 5% increase in investment income year-over-year to reach $ 3.4 billion by 2008. (It is worth noting that for the first six months of the year, investment income has grown by 9.4%).
 

iii)                 Regulated Utility Business

To be conservative, we assume growth in this division’s earnings of just 2% in 2007 and another 2% in 2008 (The big jump in earnings seen from 2005 to 2006 is largely explained by the acquisition of the Western utilities in March of 2006).
 

iv)                 Manufacturing, services and retailing

This group is now firing up on all cylinders… Last year it earned 25% return on tangible net worth!
 
We expect continued growth going forward but again, in sake of being conservative we are projecting 5% growth in after-tax earnings for two years. After-tax earnings should approach $ 2.24 billion in 2007 and $ 2.35 billion by yearend 2008.
 
Again note that so far, for the first six months of 2007, this division’s earnings have increased 17 percent versus the first six months of 2006 (largely because of the inclusion of IMC and Netjets improved results), we believe Netjets will continue to deliver solid growth for the next couple of years because of improving margins in the US network and pent-up demand in Europe.
 

v)                  Finance and Financial Products

Since this division’s results are largely influenced by Mr. Buffet’s opportunistic trading results we simply take on Clayton home’s, CORT and XTRA’s results and grow them at a conservative 2% year-over-year pace.

 

                So what are Berkshire’s operating units worth?

                                              

2008E

Insurance - underwriting

 $           1,860

Insurance - investment income

3,400

Utilities and energy

921

Manufacturing, service and retailing

2,349

Finance and financial products

762

Net earnings excl. Investment gains/losses

9,292

Average common shares outstanding

1,541,807

 

Net earnings per common share

 

$            6,027

 

 
Mr. Buffett has hinted to using a 11 to 13 pre-tax multiple to value Berkshire’s operating businesses (see 1996-1999 annual reports), which roughly equates to a 15 to 18 after-tax multiple.
 
We like to be conservative and use 15x after-tax but you can play with the numbers and reach a value yourself. It is our opinion that somewhere between 14 and 16 times after-tax is reasonable.
 

After-tax multiple

14

15

16

2008 EPS

        6,027

         6,027

         6,027

Fair value op. biz.

      84,378

       90,405

       96,432

 

 

 

 

We believe that conservatively calculated, Berkshire’s operating units should be worth between $84,000 and $96,000 per-share by the end of 2008.

               

              Berkshire’s Intrinsic Value

Operating Businesses

         84,378

      90,405

       96,432

Investments per-share

         92,300

      92,300

       92,300

Excess cash generated

         12,000

      12,000

       12,000

Berkshire's Fair Value (08)

        188,678

    194,705

     200,732

               

 

 
 
We estimate that Berkshire’s intrinsic value, conservatively calculated, should lie somewhere between $188,000 and $200,000 per-share by the end of 2008.

 

II.                  The growth story

It is sometimes forgotten just how fast has Mr. Buffett and his group of managers managed to compound earnings over time…
 
As mentioned in Berkshire’s latest annual report, the company’s pre-tax earnings per share (operating companies earnings, excluding insurance), have compounded at a stunning rate of 31.7%  during the last 10 years and 17.9% since 1965!
 
In terms of value created by the investments made by Mr. Buffett, the record is much better known but stunning as well. Berkshire’s per-share investments have grown at a 27.5% rate during the last 10 years and at 12.6% since 1965.

 

III.                Some of the common concerns shared by the investment community

 
a)      Will Mr. Buffett be able to continue deploy Berkshire’s cash as he has in the past?
 
Mr. Buffett’s net purchases of equity securities during 2006 and 2005 were $5.4 and $6.3 billion respectively. During the same period, Berkshire purchased seven businesses (Forest River Inc, Medical Protective, Iscar Metalworking, Russell Corp, Applied Underwriters, PacifiCorp and Business Wire), for an aggregate of $12.6 billion. So, during the last couple of years he’s effectively deployed $24.3 billion of cash. During 2007, he’s been quite active as well as indicated by his latest railroad filings.
 
 
b)      Who will succeed Mr. Buffett and what will happen with Berkshire when he’s no longer running it?
 
In our opinion succession fears are overblown. Each of the Berkshire’s operating companies are run by very talented managers/owners that were hand-picked by Mr. Buffett and Mr. Munger for their business talent and integrity. Those businesses will continue doing well long after Mr. Buffett is gone. In terms of the performance of Berkshire’s current investments, they are all high quality, deep moat, well managed companies that should continue appreciating over time albeit a more modest pace. Furthermore, Mr. Buffett has initiated a search for capable managers that should replace him in the future.
 
Finally, Mr. Buffett’s health is excellent at his 77 years of age. A testament that we should all drink 10 cherry colas a day to stay fit!
 
 

IV.                Possible Catalysts

 

a)      Hurricane season coming to an end with no big super cat event in 2007.

b)      Berkshire’s portfolio of publicly traded securities has appreciated around 6% since its latest filing.

c)       Further disclosure of investments made by Mr. Buffett and possible trading gains realized during the recent market correction.

d)      Continued correction in the equity markets.

 

 

 

 

V.                  Risks

 

a)      Large super-cat event that would depress the insurance division’s earnings.

b)      If Mr. Buffett’s health falters Berkshire’s shares could suffer temporarily.

 

 

 

 

Catalyst

a)Hurricane season coming to an end with no big super cat event in 2007.
b)Berkshire’s portfolio of publicly traded securities has appreciated around 6% since its latest filing.
c)Further disclosure of investments made by Mr. Buffett and possible trading gains realized during the recent market correction.
d)Continued correction in the equity markets.
    sort by   Expand   New

    Description

    We believe the discount at which Berkshire Hathaway trades today versus its intrinsic value is as large as it has been in the past and only comparable to that which briefly existed in early 2000 and prompted Mr. Buffett to publicly state his intention of repurchasing Berkshire’s stock at that time.   

    Berkshire was originally written-up at this forum by nish697 a couple of years ago.   At that time nish estimated that the company’s fair value would be close to $132,000 per-share 18 to 24 months out.  We now know, with the benefit of hindsight, that thanks to Berkshire’s managers’ great execution and to Mr. Buffett’s investment skills, the company’s intrinsic value by yearend 2006 was roughly in line with that which nish predicted would be.

    It is our estimate that Berkshire’s fair value, after two continuous years of stellar results from its insurance division lies somewhere between $150,000 and $160,000 per-share at this time. Using very conservative assumptions and nothing more than sixth grade math, it is our estimation that by yearend 2008, Berkshire’s intrinsic value should approximate $200,000 per-share.

    Berkshire’s growth in value has far outpaced the appreciation of its shares and although this has probably been the case for the last two years, we think that the divergence between value and price has never been as wide as it is today. Berkshire trades at what we believe are depressed prices and should return close to 55% within the next 12-18 months, if it reaches its fair value, with minimal downside risk.

    Because I suspect this is a very well known company for most fellow members of this club, I will not waste your time with an introduction and concentrate instead on the company’s valuation, its growth history, touch upon what we believe are some of the key concerns weighing on investors today and finally discuss possible catalysts and potential risks to our thesis.

    Without further due,


     

    I.                    Valuation

     

    Berkshire’s valuation at current prices ($129,000 per-share)

    Although we recognize that there are different ways to get to Berkshire’s intrinsic value, we prefer to take a very simplistic approach which is to value its operating units, add the per-share value of the investments in publicly traded securities owned by the company and finally add any excess cash generated.
     
    As of yearend 2006, Berkshire’s investments per-share were $80,636. Let’s assume a conservative 7% appreciation and by the end of 2008, investments per-share should be somewhere around $92,300.
     
    Berkshire is generating around $ 9 billion of cash every year, let’s assume $ 18 billion of excess cash in two years or roughly $12,000 per-share excess cash by the end of 2008 versus 2006.              
     
     

    Berkshire's share price

                           129,000

    - Investments

                             92,300

    - Excess cash

                             12,000

    Value of operating businesses

                             24,700

    2008E after-tax op. earnings

                              6,027

    after-tax implied multiple

                                  4.1

     

     

     

     
     
    We are adjusting 2008 underwriting earnings downward because we believe that 2006 and 2007 underwriting results are not sustainable given the absence of any large super-cat event during both years.  If this continues to be the case for some years Berkshire’s earnings will be far larger than what we predict but we just can’t count on that happening.
     
    Basically, at current prices you get Berkshire’s operating divisions (insurance, utilities, manufacturing, services, retailing), for 4 times after-tax 2008 normalized earnings. Essentially you are paying 4x for a collection of businesses that have been growing pre-tax earnings at a compounded rate of 31.7% for the last 10 years and have great prospects ahead of them.

     What is the normalized earnings power of Berkshire’s op. businesses?

    2006

    2005

    2004

    Insurance – underwriting

     $           2,485

     $              27

     $          1,008

    Insurance - investment income

    3,120

    2,412

    2,045

    Utilities and energy

    885

    523

    237

    Manufacturing, service and retailing

    2,131

    1,646

    1,540

    Finance and financial products

    732

    514

    373

    Other

    -47

    -124

    -154

    Investment and derivative gains/losses

    1,709

    3,530

    2,259

    Net earnings

     $          11,015

     $          8,528

     $          7,308

     

     

     

     

     

     

     

     

    i)                    Insurance – Underwriting

     
    The absence of super-cat’s during 2006 combined with huge premiums after the losses brought by both Rita and Katrina contributed to last year’s extraordinary underwriting results.
     
    This year will likely be the second stellar year in a row thanks to a so far very benign hurricane season and the absence of large super-cat’s as well.  It wouldn’t surprise me to see underwriting profits approach $ 3 bn this year.
     
    However, as Mr. Buffett has repeatedly said, we just can’t count with such stellar results repeating themselves in the future.
     
    As of yearend 2006, Berkshire’s float was $ 50.9 billion and if you add the retroactive reinsurance contract written with Equitas, which adds $ 7 billion, float should be around $ 59 to $60 billion as of today. We assume that float grows modestly to around $62 billion by yearend 2008 and that underwriting profit is a modest 3% or $ 1.86 billion that year. That is a 25% haircut from 2006 underwriting results which we believe is conservative enough.

     

    ii)                   Insurance -  Investment Income

    Investment income has grown at an after-tax rate of 23-25% during the last three or four years putting to rest all doubts on Mr. Buffett’s ability to invest Berkshire’s large sums of cash.
     
    To be conservative, let’s assume only a 5% increase in investment income year-over-year to reach $ 3.4 billion by 2008. (It is worth noting that for the first six months of the year, investment income has grown by 9.4%).
     

    iii)                 Regulated Utility Business

    To be conservative, we assume growth in this division’s earnings of just 2% in 2007 and another 2% in 2008 (The big jump in earnings seen from 2005 to 2006 is largely explained by the acquisition of the Western utilities in March of 2006).
     

    iv)                 Manufacturing, services and retailing

    This group is now firing up on all cylinders… Last year it earned 25% return on tangible net worth!
     
    We expect continued growth going forward but again, in sake of being conservative we are projecting 5% growth in after-tax earnings for two years. After-tax earnings should approach $ 2.24 billion in 2007 and $ 2.35 billion by yearend 2008.
     
    Again note that so far, for the first six months of 2007, this division’s earnings have increased 17 percent versus the first six months of 2006 (largely because of the inclusion of IMC and Netjets improved results), we believe Netjets will continue to deliver solid growth for the next couple of years because of improving margins in the US network and pent-up demand in Europe.
     

    v)                  Finance and Financial Products

    Since this division’s results are largely influenced by Mr. Buffet’s opportunistic trading results we simply take on Clayton home’s, CORT and XTRA’s results and grow them at a conservative 2% year-over-year pace.

     

                    So what are Berkshire’s operating units worth?

                                                  

    2008E

    Insurance - underwriting

     $           1,860

    Insurance - investment income

    3,400

    Utilities and energy

    921

    Manufacturing, service and retailing

    2,349

    Finance and financial products

    762

    Net earnings excl. Investment gains/losses

    9,292

    Average common shares outstanding

    1,541,807

     

    Net earnings per common share

     

    $            6,027

     

     
    Mr. Buffett has hinted to using a 11 to 13 pre-tax multiple to value Berkshire’s operating businesses (see 1996-1999 annual reports), which roughly equates to a 15 to 18 after-tax multiple.
     
    We like to be conservative and use 15x after-tax but you can play with the numbers and reach a value yourself. It is our opinion that somewhere between 14 and 16 times after-tax is reasonable.
     

    After-tax multiple

    14

    15

    16

    2008 EPS

            6,027

             6,027

             6,027

    Fair value op. biz.

          84,378

           90,405

           96,432

     

     

     

     

    We believe that conservatively calculated, Berkshire’s operating units should be worth between $84,000 and $96,000 per-share by the end of 2008.

                   

                  Berkshire’s Intrinsic Value

    Operating Businesses

             84,378

          90,405

           96,432

    Investments per-share

             92,300

          92,300

           92,300

    Excess cash generated

             12,000

          12,000

           12,000

    Berkshire's Fair Value (08)

            188,678

        194,705

         200,732

                   

     

     
     
    We estimate that Berkshire’s intrinsic value, conservatively calculated, should lie somewhere between $188,000 and $200,000 per-share by the end of 2008.

     

    II.                  The growth story

    It is sometimes forgotten just how fast has Mr. Buffett and his group of managers managed to compound earnings over time…
     
    As mentioned in Berkshire’s latest annual report, the company’s pre-tax earnings per share (operating companies earnings, excluding insurance), have compounded at a stunning rate of 31.7%  during the last 10 years and 17.9% since 1965!
     
    In terms of value created by the investments made by Mr. Buffett, the record is much better known but stunning as well. Berkshire’s per-share investments have grown at a 27.5% rate during the last 10 years and at 12.6% since 1965.

     

    III.                Some of the common concerns shared by the investment community

     
    a)      Will Mr. Buffett be able to continue deploy Berkshire’s cash as he has in the past?
     
    Mr. Buffett’s net purchases of equity securities during 2006 and 2005 were $5.4 and $6.3 billion respectively. During the same period, Berkshire purchased seven businesses (Forest River Inc, Medical Protective, Iscar Metalworking, Russell Corp, Applied Underwriters, PacifiCorp and Business Wire), for an aggregate of $12.6 billion. So, during the last couple of years he’s effectively deployed $24.3 billion of cash. During 2007, he’s been quite active as well as indicated by his latest railroad filings.
     
     
    b)      Who will succeed Mr. Buffett and what will happen with Berkshire when he’s no longer running it?
     
    In our opinion succession fears are overblown. Each of the Berkshire’s operating companies are run by very talented managers/owners that were hand-picked by Mr. Buffett and Mr. Munger for their business talent and integrity. Those businesses will continue doing well long after Mr. Buffett is gone. In terms of the performance of Berkshire’s current investments, they are all high quality, deep moat, well managed companies that should continue appreciating over time albeit a more modest pace. Furthermore, Mr. Buffett has initiated a search for capable managers that should replace him in the future.
     
    Finally, Mr. Buffett’s health is excellent at his 77 years of age. A testament that we should all drink 10 cherry colas a day to stay fit!
     
     

    IV.                Possible Catalysts

     

    a)      Hurricane season coming to an end with no big super cat event in 2007.

    b)      Berkshire’s portfolio of publicly traded securities has appreciated around 6% since its latest filing.

    c)       Further disclosure of investments made by Mr. Buffett and possible trading gains realized during the recent market correction.

    d)      Continued correction in the equity markets.

     

     

     

     

    V.                  Risks

     

    a)      Large super-cat event that would depress the insurance division’s earnings.

    b)      If Mr. Buffett’s health falters Berkshire’s shares could suffer temporarily.

     

     

     

     

    Catalyst

    a)Hurricane season coming to an end with no big super cat event in 2007.
    b)Berkshire’s portfolio of publicly traded securities has appreciated around 6% since its latest filing.
    c)Further disclosure of investments made by Mr. Buffett and possible trading gains realized during the recent market correction.
    d)Continued correction in the equity markets.

    Messages


    SubjectNew Writeup
    Entry10/18/2007 06:22 PM
    Memberflubber926
    Description:

    We believe the discount at which Berkshire Hathaway trades today versus its intrinsic value is as large as it has been in the past and only comparable to that which briefly existed in early 2000 and prompted Mr. Buffett to publicly state his intention of repurchasing Berkshire’s stock at that time.   

    Berkshire was originally written-up at this forum by nish697 a couple of years ago.   At that time nish estimated that the company’s fair value would be close to $132,000 per-share 18 to 24 months out.  We now know, with the benefit of hindsight, that thanks to Berkshire’s managers’ great execution and to Mr. Buffett’s investment skills, the company’s intrinsic value by yearend 2006 was roughly in line with that which nish predicted would be.

    It is our estimate that Berkshire’s fair value, after two continuous years of stellar results from its insurance division lies somewhere between $150,000 and $160,000 per-share at this time. Using very conservative assumptions and nothing more than sixth grade math, it is our estimation that by yearend 2008, Berkshire’s intrinsic value should approximate $200,000 per-share.

    Berkshire’s growth in value has far outpaced the appreciation of its shares and although this has probably been the case for the last two years, we think that the divergence between value and price has never been as wide as it is today. Berkshire trades at what we believe are depressed prices and should return close to 55% within the next 12-18 months, if it reaches its fair value, with minimal downside risk.

    Because I suspect this is a very well known company for most fellow members of this club, I will not waste your time with an introduction and concentrate instead on the company’s valuation, its growth history, touch upon what we believe are some of the key concerns weighing on investors today and finally discuss possible catalysts and potential risks to our thesis.

    Without further due,


     

    I.                    Valuation

     

    Berkshire’s valuation at current prices ($129,000 per-share)

    Although we recognize that there are different ways to get to Berkshire’s intrinsic value, we prefer to take a very simplistic approach which is to value its operating units, add the per-share value of the investments in publicly traded securities owned by the company and finally add any excess cash generated.
     
    As of yearend 2006, Berkshire’s investments per-share were $80,636. Let’s assume a conservative 7% appreciation and by the end of 2008, investments per-share should be somewhere around $92,300.
     
    Berkshire is generating around $ 9 billion of cash every year, let’s assume $ 18 billion of excess cash in two years or roughly $12,000 per-share excess cash by the end of 2008 versus 2006.              
     
     


    Subjectpdf
    Entry10/18/2007 06:31 PM
    Memberflubber926
    Unfortunately tables moved when text was converted to pdf format.
    I am contacting VIC admin for help!
    In the meantime, please accept my apologies and read the post without converting to pdf...

    Subjectre: double counting
    Entry10/18/2007 07:38 PM
    Memberflubber926
    Thanks for your remarks thomas! - you make a good point..

    My reasoning was as follows:
    As of yearend 2006, Berkshire's portfolio of investments (The Amex, KO, BUD, JNJ. etc), were worth around $62 billion.

    However at the end of 06, Berkshire's cash+fixed income securities amounted to roughly $63 billion. - If we assume that Mr. Buffett will be able to invest half of that in two years, even a 10% after-tax return will roughly generate $3.4 billion of investment income. - Cash alone at 3% should generate close to $1 billion in interest earnings per year...
    That is how we got to $3.4 bn of investment income in 08.

    Should've been clearer on that, my apologies. - Consider that during 2005-2006 $24.3 billion were put to work...

    Assuming he'll be able to invest roughly $33-34 billion in two years didn't sound too unreasonable to me, but even if you could trim that down to $24 billion at 10%, your intrinsic value would be reduced by about $14-15 billion or around $9,000 to $10,000 per-share...

    Subjectre: double counting
    Entry10/18/2007 09:04 PM
    Memberthomas434
    Thanks for the reply. I didn't mean to be nit picky - I completely agree with your thesis that Berkshire is undervalued no matter how one wants to calculate intrinsic value.

    Subjectthanks for the post
    Entry10/18/2007 09:10 PM
    Membersag301
    Thank you for your post. I have seen similar analysis in other forums and have always wanted to understand the underlying logic. The analysis seem to be a sum of the parts (investments per share, plus cash generated, plus owned businesses appropriately capitalized = some value) yet there is no deduction for liabilities, i.e the float and deferred taxes supporting the investments. What is the economic logic for excluding liabilities from the sum of the parts? It is unconventional. I am not suggesting that float and deferred tax liabilities have the same economic consequence of traditional debt, but it is not apparent to me why they are entirely ignored. I would tend to think that float and deferred taxes need to be treated very differently from each other, yet it seems that you have treated them in the same manner (ignored), why have you chosen to treat them in the same manner?

    What are your underlying assumptions for US tax policy and/or Berkshire’s investment behavior that support excluding any mention of deferred tax liabilities from what I believe is a sum of the parts analysis?

    What are the assumptions underling the cost of float and the growth/maintenance of current levels of float that support excluding it from your sum of the parts as a liability? There are a number of insurance companies that have low cost or costless float, but I have never seen the liability excluded when analyzing other insurers, why is it appropriate to do so when considering BRK?

    There is also the problem of double counting, it seems inappropriate to give credit for investments owned by the company as an asset (Investments per share), then capitalize the earnings on those investments (Insurance investment income) and then add the two together to get a value. It appears that you have done that in your analysis. Does that approach not have the effect of counting the same asset twice, once from the balance sheet (Investments) and once through the income statement (Insurance investment income)?

    I’m I big fan of BRK and the buff/munger culture, but I’ve always thought of the company as a hodgepodge conglomerate attached to a massively over capitalized insurance company --- both of which kick off excess capital to be deployed by the worlds best allocator --- quite a mouse trap, worthy of a premium multiple, but very difficult to think of as a sum of the parts because the parts seem to rely on/reinforce each other, to yield a value that is greater than the appropriately calculated sum of the parts --- I’ve always thought that the likely growth in float and probability of it remaining low or negative cost would be greatly reduced if : the insurance operations weren’t over capitalized, weren’t attached to an industrial conglomerate, or if buffett were gone. Also, the likely growth and relative certainty of that growth, change depending on your confidence in the capital allocator at the top of the structure.

    But, if you want to do a sum of the parts, fine, (useful as a floor valuation when buffet is gone), but why not approach the insurance operations in the same manner one would approach any other insurance operation, given proper consideration for: excess capital, economic earnings of equity holdings, and adjusting for suboptimal cash return and super optimal buffet trading returns?

    Sorry for the long question, but the sum of the parts excluding liabilities has always bugged me intellectually. Though I think you can get to somewhat similar valuations using different analysis.

    SubjectQuestions
    Entry10/18/2007 11:17 PM
    Memberdavid101
    Flubber,

    At the risk of attacking the sacred cow...

    1. Given two years of benign cat losses for the insurance business, what kind of contraction in insurance premiums do you expect and will it impact float?

    2. The stock has gone from $110K to $129K in the last two months since the credit turmoil started. What are your thoughts about this recent uptick being a flight to safety?

    3. Where has Berkshire traded in the past with respect to intrinsic value?

    David

    Subjectre: sag
    Entry10/19/2007 03:37 PM
    Memberflubber926
    Sag,
    Thanks for your comments and no worries about the length of the question, you certainly raise interesting points...

    With regards to the need to deduct all liabilities (float and deferred taxes), I could not agree more with you if we're turning down the switch in a liquidation scenario.
    Buffett himself has talked about the need to back out float in such circumstances. As a going concern, Buffett recommended considering float as equity, after all return on float matches the return generated by BRK's other assets.
    I guess the logic behind Buffett's commentary is that you now have a 40 year track record of float growing and effectively being a negative interest loan to the company that can't be called upon.
    Since I am valuing the company as a going concern I do not see the need to deduct float or for that matter deferred taxes for the sale of the investments held by Berkshire. - Would you agree?

    I agree with you that if we deduct float and deffered taxes we can get to a floor, liquidation value. - You'd have to deduct around $50,000 per-share which gets you to a liquidation value of something around $138,000 and $150,000 per-share.

    With respct to double counting; I am taking the portfolio of securities owned+extra cash generated in 07 and 08+operating co's earnings at a multiple to get to fair value. - The underlying assumption behind $3.4bn of investment income is that as of the end of 06, BRK was sitting in around $66 bn of cash+fixed income sec. If Buffett was able to deploy half of it (growing every year), at a 10% return you get to additional value of $3.4 billion being created. I am not double counting since I am assuming new investments. - By the way, Buffett managed to invest around $27 billion between 05 and 06 so, my assumption doesn't seem far-fetched in my opinion.

    Finally, I agree with you that this company will be put to stress when Buffett is no longer at the top but I believe credit is due to BRK's managers: Jain, Santulli, etc, etc as they hold the reigns to day to day opps. Investing the excess cash at the returns Buffett has had will be near to impossible but I am confident that he'll make sure we get one or a couple of above-average pm's to succeed him and do the job.

    Again, thanks for your comments and sorry for the long reply!




    Subjectre: david 101
    Entry10/19/2007 03:55 PM
    Memberflubber926
    David,

    Let me begin by saying that I have no real input on what kind of insurance-premium contraction should we expect during the next couple of years. So far, as Buffett himself has indicated, premiums have contracted somewhat in 2007 and that has led BRK to write less policies. - I think BRK's past record of only underwriting policies when appropriately compensated stands and that should not change in the future. - With respect to float, I believe it should continue to grow albeit a slower pace. My reasoning is that BRK has become the first choice for many because of its reputation and its very solid balance sheet. BRK can take on risks that very few can and that by itself is their moat in my opinion (just look at the $7 bn reinsurance contract written with Equitas, that alone increases float by 13%).
    The underwriting profits that I assume for 08 are 25% below that of 06 and around 3% of the est. float.

    With respect to the recent run-up in the stock I tend to think that yes, flight to safety is an issue and also expectations are high as to what Mr. Buffett can do with the $66+ billion of cash (cash+fixed income inv), that BRK has in markets like the one we are seeing today.
    Nevertheless, even after this runup, I believe there's plenty of room to go...

    Finally, BRK has actually preety much always traded near its intrinsic value up until 2005. (Whitney Tilson has a nice chart showing that, check his website) I guess the shareholder base is unique and management communication with their shareholders is also preety special so that has helped maintain a nice relationship between price/value.
    Since 2005, a discount to IV has been present and I guess some possible explanations could be: most large-caps have underperformed since, fears around Buffett's/Munger's age, etc, etc. I really see no justification for the discount.
    In early 2000, Buffett publicly said that he was looking to buyback stock b/c of the price-value divergence...

    SubjectThanks for the reply and feel
    Entry10/19/2007 07:42 PM
    Membersag301
    Thanks for the reply and feel free to disregard my comments at any point as I freely acknowledge that they are some what academic.

    I’d propose a thought experiment on Float. – Imagine that I gave you an interest free loan, further imagine that the loan never has to be repaid. No question such a loan has value, at a minimum you could earn the risk free rate on the money I was allowing you to hold at no cost. What is the earnings of the risk free rate forever worth? It is basically worth the amount of the loan that I gave you. But now what if the loan were given to a corporate entity that paid taxes at the corporate level and then again at the shareholder level in the event of distributions? In that case, I think the value to the shareholder is less than the amount of the cost free loan, and depends quite a bit on federal tax policy.

    In the case of float, you have to consider the probability that the cost of the float will be negative or positive over time. And in the case where someone else is investing the money, you need to consider that their actions could result in outcomes better or worse than the risk free rate. (at lease at BRK, as long as buff is copos mentis, it is fairly safe to assume that investment actions will exceed the risk free rate and float will be at least very low cost) Because of the importance of very long term assumptions with regard to the value of float, buff’s age and my belief that it will be very difficult to sustain the investment and cost/growth of float performance post buff, I would argue that in a conservative analysis, float should not be considered equity and should, at least for part of it, be included as a liability.

    I think that the issues raised above are relevant to how one ought to think about float. Float just isn’t equity and depending on circumstance it can be better (if it is negative cost and growing like crazy) or a bunch worse (if it is high cost or shrinking like crazy).

    I also think that you need to treat some part of deferred taxes as a liability. Much of the deferred tax is unlikely to be paid near term, but as witnessed by his recent PetroChina sales some amount of the deferred tax will defiantly be paid. To the extent you believe some holdings are forever, I think you should back them out of you investments per share number, consider the look trough earnings on those holdings and exclude the deferred taxes from the liabilities. To the extent holdings aren’t forever, then appropriate taxes should be deducted in a sum of the parts analysis. If anyone deserves credit for not paying taxes, it is John Malone, yet his companies consistently trades as if those taxes will be paid.

    As for the double counting, I think we are talking past each other.

    You wrote-
    “With respct to double counting; I am taking the portfolio of
    securities owned+extra cash generated in 07 and 08+operating co's earnings at a multiple
    to get to fair value. - The underlying assumption behind $3.4bn of investment
    income is that as of the end of 06, BRK was sitting in around $66 bn of cash+fixed income
    sec. If Buffett was able to deploy half of it (growing every year), at a 10% return
    you get to additional value of $3.4 billion being created. I am not double counting
    since I am assuming new investments.”

    In your analysis, you take all of BRK’s investments at year end 2006 (cash 37.9bn, Fixed income of $25.3bn, Equity of $61.5bn and other of $.9 – it seems like other has been left out, but no matter-) add them to get $80,636 ($125.6/1.541) per share. Then you assume a 7% growth rate (very reasonable) and roll forward 2 years to get to $92,300 per share as of 2008.

    I guess my point is that when you say that the investment income of 2008 (the $3.4bn) comes from investments made out of the $66bn that is in cash and fixed income at YE 2006, I’d say that if you do that you have double counted because that capital (the $66bn form which you assume he invests half and earns 10% to get $3.4bn in earning in 2008) is included in you investment per share amount.

    The earnings likely to be realized from the investments per share (conceptually it doesn’t matter if the investments are in cash, fixed income or equities – or if the investments are switched from cash and into equities) in 2 years needs to be excluded from your valuation because you are all ready including the assets that create those earning in your investments per share number. In order to avoid double counting, if you wanted to capitalize the $3.4bn of earnings – then you must back out the $33bn (one half of $66bn) that you suggest will create the earnings.

    I actually don’t think it is conceptually right to think of the Investment earnings come from one part or another of the portfolio. Also, because of BRK’s huge gains in its investment portfolio, the company could report almost any investment income it desired. I think it is a mistake to capitalize BRK’s investment income.


    For a sanity check, try applying the same analysis you’ve used for BRK’s insurance operations to PGR --- you’ll see that it produces an unreasonably high valuation. (about $56 per share with a 15x which is about 35x traditional earnings and more than 7x of book)

    For what it is worth, I think it is appropriate to consider BRK as a fast growing, overcapitalized company trading at a reasonable multiple with major long-term management issues. I think you would get a bunch less than $138k to $150k in a liquidation if you didn’t double count the investments/investment earnings. -- oh well, its worth $150k to go to Omaha each spring and hear the gospel.

    SubjectInsurance stand-alone valuatio
    Entry10/20/2007 12:32 PM
    Membermark744
    Thanks for the idea. Touching on the double-counting issue, what do you think are the appropriate amount of invested assets (including cash, fixed income and equity securities) that would need to be allocated to the insurance business, as if it were operating as a stand-alone company with a AAA credit rating? In my opinion, this is crucial to the valuation of BRK. I agree with approaching this on a sum-of-the-parts basis, but I would think that a more accurate measure of intrinsic value would be the sum of 1) the value of operating businesses (multiple of earnings), 2) the insurance business valuation, which would be a multiple of operating earnings, LESS the appropriate amount of cash, bonds and stocks to maintain profitability/strong capital at a AAA-credit rating; 3) Plus any excess cash, and investments NOT needed to capitalize the insurance business.

    SubjectJust some thoughts
    Entry10/20/2007 04:14 PM
    Memberdanarb860
    IO don't think BRK is expensive but I think in all areas over a longer period of time, all the concerns raised hvae a reasonable liklihood of playing out, in other words have high future value with undercertain present value.

    1) Float. Even meaningfully positive cost of float is not a problem in future years if returns are very positive. However, even negative cost of float is a problem if returns are meaningfully negative. In that respect, if returns are negative and likely to continue, then even negative clost of float is no blessing. At the end of the day, it is a pure spread business, albeit in the hands of a master.

    What will returns be going forward. There are plenty of reasons to be sanguine as a more volatile world plays into the great Buffet. However, two caveats. Big profits made 03-06 or so from big distressed investments made in 02 and '03. Note the capital gains BRK has in the last number of years that flow through its earnings. I have no idea what multiple to put on these. Maybe same opportunity that BRK can capitablize on now in sub-prime. But I think that given the portfolio size, big returns requires big disclocations. A big percent of his float growth depends upon continued growth of a large equity portfolio will into the 6th year of a bull market.

    3) Woody Allen talked about wanting to achieve immortality not through his works but by living forever. Alas, he will eventually have to achieve it through his works as will eventually Buffett. And what happens then? Maybe the company stays together and moves along as is. Will not likely do as well. However, maybe the company breaks up which would create a lot of value except... what about the deferred capital gains. Maybe parent company becomes investment company which might solve the problem. Maybe all the insurance businesses stay as one so equities there can stay and be held. However it is done, compared to Malone who along with his companies held much bigger stakes in his other companies in related businesses, BR
    K's holdings are smaller stake, passive for the most part, and in unrelated businsses. This tends to reduce the chance of some Houdini moves.




    Subjectre: double counting
    Entry10/21/2007 09:17 PM
    Membercarbone959
    A little comment for the two of you talking past each other. Clearly one cannot double count the asset and the earnings it produces, but this axiom only applies when you value the asset according to its intrinsic value. It doesn't apply when you're using some kind of NAV or MTM value.
    Example: I have a building with tenants. Over many decades and with a stable population, let's say its market price grows at the rate of inflation. That value is permanent. But you also have the cash flow from the renting business: this is not double-counting, it's simple valuation: You;re taking your Free Cash Flow from t=0 to t=T and adding a terminal value (market price + inflation for 0 to T).
    So in the case of an investment portfolio, it's the same thing. If you value it using NAV, then all dividends, interest and free cash flow will probably have to be added separately and it's not double counting. Furthermore NAV doesn't take into account over/under-valuations. Now if you value an asset by estimating its intrinsic value, you would have thrown in the FCF and anything else you want. So in this case adding in the earnings would be double counting because your intrinsic value encompasses everything.
    Buffett's investment portfolio is not so diversified, so maybe it's simpler to just ballpark the intrinsic value of each major investment and then there's no need to count any earnings after that.

    Subjectre:Mark744
    Entry10/21/2007 10:18 PM
    Memberjim211
    Thats a great post. Very clearly stated and very elegant way of valuing Berkshire and solves the double-counting issue which is always so hard (and I agree with others is a big flaw in this VIC analysis). We all have our ways of valuing Berkshire, but I've always wanted to figure out how to separate what really is excess capital from what is required to back the insurance business. The excess cash you argue is what is in excess of what is necessary maintain a AAA rating. Thats really sound thinking.

    So if we use Ambac's or MBIA's balance sheet, or the AAA tranch of a mortgage backed to determine the threshhold for a AAA rating...only kidding. seriously though, how would you quantify that? I don't think its as simple as it looks as Berkshire has SOOOOOO much unused debt capacity on some of its operating businesses so any simple analysis might be way too conservative.

    Subjectmark 744
    Entry10/22/2007 10:23 AM
    Membersag301
    I agree with your methodology --- I might use look through earnings or "potential earnings if redeployed" on the excess capital



    Subjectre: sag, Thanks for your reply
    Entry10/22/2007 05:16 PM
    Memberflubber926
    Sag,

    You make very good points and I finally understand and agree to your point on double counting. - I should've backed-out $33 bn from the valuation which is what theoretically will yield $3.4 bn of investment income two years out. - $33 bn/1.541 rougly equals $21,000 per-share that we'd have to deduct from BRK's fair value.

    With respect to what should be done between deducting the cash that will produce investment income two years out and capitalizing the investment income or simply make no deductions to cash/investments and leave out investment income from the op. biz. fair value, I have mixed feelings...

    For one part, I do not believe PGR's investment income is quite comparable to that of BRK because we are not talking about a liquidation scenario here, we are valuing an ongoing concern, and Buffett's track record as a capital allocator is worth something.

    On the other hand, I agree that the most conservative way around this would be to leave cash and investments as they are and don't count investment income when capitalizing the op. biz earnings. - In that case, op. businesses would be worth around $39,000 per-share to get to an intrinsic value of BRK of something around $144,000 per-share.

    Again, the only problem I have with that approach is that in my opinion, it gives little value to having Mr. Buffett at the helm in charge of the investment decisions, which is something we have today.

    I guess in a very conservative scenario with very modest assumptions you arrive to a fair value of 144K per-share and with less conservative assumptions (capitalizing inv. income and deducting $33 bn cash), you get to an IV of roughly $174K per-share.

    I'd be comfortable somewhere in between that $144-174K range.

    I guess that with the stock trading at $125K or so, I see little downside, good upside.

    In my opinion, one of the most valuable assets of membership in the VIC, is being able to discuss ideas, receive feedback and thus learn from fellow members. I am grateful for that and appreciate your comments.



    Subjectre: mark744
    Entry10/22/2007 05:30 PM
    Memberflubber926
    Mark,
    Thanks for your comments.
    I agree with the method you suggest as a way to get to BRK's fair value, however in my opinion, it applies more to a liquidation scenario with Buffett no longer around.

    I think Mr. Buffett's record as capital allocator, the 40+ years of costless, growing float, are worth something... Of course, the question is how much?

    I guess the most consercative way to value BRK as an ongoing concern is: cash/investments+op. biz earnings capitalized+excess cash generated. If you go that way (see prior post to sag), you get to a IV of around $144,000 per-share. If you give some kind of value to Mr. Buffett being the one investing all that cash and being able to produce above-par results, then you'd take out cash from the valuation and capitalize inv. income at some multiple. That exercise yields a FV of around $174,000 per-share. My opinion is that fair value lies somewhere in between of that range...


    Subjectre: carbone
    Entry10/22/2007 05:42 PM
    Memberflubber926
    Carbone,

    Thanks for your post, I completely agree with what you say...

    Please read my reply to sag but I guess, BRK's intrinsic value lies somewhere in between taking cash/investments+op. biz earnings capitalized+excess cash generated (which in my opinion is closer to a liquidation value since you are giving little credit to Mr. Buffett's history in producing above average results and BRK's history of cost-less, growing float), and the approach discussed in the writeup, adjusted for the cash invested, which solves the double counting issue.

    Of course, it would be far more accurate if instead of valuing BRK's per-share investments at market prices, we value them at their estimated intrinsic value.


    Subjectre: Jim211
    Entry10/23/2007 02:08 PM
    Membermark744
    Hi Jim, yeah, I think that you'd just have to look at other P&C insurance companies and ascertain what their long-term annaul pre-tax earnings are as a percent of what their capital employed is (debt + equity) and impute Berkshire's capital "allocated" to insurance from its pre-tax earnings. You'd probably have to look at multi-year averages and keep in mind that at a AAA rating, Berkshire's insurance ops would probably have minimal debt assigned to it--this wouldn't matter as much, as you're interested in doing earnings as a % of capital, and with berkshire, the capial would be assumed to be all equity). Comps that can probably be looked at are AIG (double AA rated) and State Farm (AA rated - a mutal fund company, however you could look at their statutory statements). Others might include Allstate (single-A rated), XL Capital (low single-A).

    Subjectre: flubber
    Entry10/23/2007 02:25 PM
    Membercarbone959
    By the way, I think the IV method should apply to the cash as well because of BRK's superior skills. So after deducting cash needed to maintain a stable insurance biz, I wouldn't value the cash dollar-for-dollar, but maybe at somewhere between 1.1x - 1.5x book. Where exactly... I don't know. At 1.5x you're adding another 20k of value. If securities markets eventually suffer big discounts, it's not that difficult to fill up for $50B.
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