Berkshire Hathaway BRK.A
April 21, 2005 - 4:00pm EST by
nish697
2005 2006
Price: 83,900.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in M): 129,038 P/FCF
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT

Sign up for free guest access to view investment idea with a 45 days delay.

 

Description

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.

Catalyst

Value is its own catalyst. Over time it will be appropriately weighed and valued with a good result for investors.
    sort by   Expand   New

    Description

    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.

    Catalyst

    Value is its own catalyst. Over time it will be appropriately weighed and valued with a good result for investors.

    Messages


    Subjectsupercat question
    Entry04/21/2005 05:08 PM
    Memberelan19
    For re-insurance companies - is it really fair to think that all that cash is owned by the shareholders, given that huge claims will eventually be filed (timing and magnitude unknown)? Maybe you or others with insurance expertise can share how you think about cash reserves of a reinsurance company.

    Let me frame the question with a hypothetical reinsurance company:

    Annual Sales: $10 billion
    Annual Free Cash Flow (generated half from float, half from operations): $1 billion
    Cash hord at Year 0: $10 billion

    In normal years, payout is zero. Once every 10 years, there is a huge payout that varies between $5 to $10 billion for the year.

    At the end of the 10 years, there will be $10 to $15 billion of cash. At the end of 20 years, $10 to $20 billion. But at some points in between, cash could fall to zero.

    So what is the value of this cash?

    The simple answer is whatever it is at the moment. Does that mean this company is much more valuable after a string of years with no supercatastrophes, but all of a sudden much less valuable when a supercatastrophe occurs? Or would it make more sense to consider some of the cash as reserved for the supercatastrophe that will inevitably occur, and therefore not counted as part of intrinsic value?

    Followup question: What is the maximum possible payout that could occur in a single year if every existing supercat policy was triggered at its maximum level? Or if this is a ridiculous possibility, what if 1/10 of the policies were triggered?

    Apologies if my question is very naive - insurance is not an industry I've studied so I'm just wanting to learn the right way to think about this (and maybe make me comfortable enough to invest in BRK.A).

    Subjectwhen warren buffet gets sick o
    Entry04/21/2005 06:50 PM
    Memberissambres839
    This stock loses all of its premium and cache.

    I believe he is 72, so he is getting up there in years.

    Also, I believe investors are smart and will slowly start removing that premium as he gets older.

    Subjectno buyback?
    Entry04/22/2005 12:49 AM
    Memberclancy836
    I think you make your case nicely. But it begs the question, why are they are continuing to sit on all that cash with that same opportunity in front of them? Buffett surely isn't conteplating a raft of opportunities that exceed the average annualized returns of over 25% you arrive at. Yet while BRK may be buying BUD, it hasn't been buying itself.

    Can shares of BUD really be a superior investment? Or is it a case of barely missing the promised threshold of "well below intrinsic value, conservatively calculated"? There's an opportunity cost to reticence, even if due to modesty or conservatism.

    SubjectBuffett's life expectancy
    Entry04/22/2005 08:00 AM
    Memberzzz007
    Statistically, Buffett may have 10 years of life left, but between the Dairy Queen cheeseburgers, gallons of Coke syrup, and truckloads of Sees candy that he inhales there's a decent argument for a shorter remaining time span. I don't think its any coincidence that "Buffett" is awfully close to "buffet", as in the all-you-can-eat kind at Denny's.

    SubjectDoubt Buffett buying BUD
    Entry04/22/2005 11:18 AM
    Membervaluearb856
    It's a good bet that Lou Simpson (who runs GEICO's portfolio) is buying BUD, not Buffett. Warren is very private about what he buys, I doubt he'd authorize BUD to issue that press release.

    SubjectGreat idea
    Entry04/22/2005 11:34 AM
    Membernassau799
    I've thought about writing this up several times but didn't because I thought I'd be laughed out of VIC for such an obvious idea. Nish did it better here than I ever could. He nails the basics. Upside is meaningful, downside is minimal, and you have a Fort Knox balance sheet. This is my largest discretionary position as it is and I'm thinking about buying more.

    SubjectBUD
    Entry04/22/2005 01:32 PM
    Memberscrooge833
    It could be Buffett. I think people are missing the fact that that Bud's China growth has huge potential. I remember some other company has done this before. I think Buffett would usually call after he bought. I think it was Gannett that issued a press release like that way back.

    Subjectsleep at night
    Entry04/22/2005 02:25 PM
    Memberdanarb860
    I thought that perhaps that is how you felt....i don't know who you are, but I promise you, I would sleep better at night if YOU were running it as opposed to me.

    Subjectsleep at night
    Entry04/22/2005 02:25 PM
    Memberdanarb860
    I thought that perhaps that is how you felt....i don't know who you are, but I promise you, I would sleep better at night if YOU were running it as opposed to me.

    SubjectCash & IV
    Entry04/22/2005 02:57 PM
    Memberdavid101
    Nish,

    I like Berkshire and think the current prices are starting to look interesting, but I have to quibble about your adding the full value of cash and bonds to intrinsic value for two reasons. The first issue is that you did not net out debt. Secondly, and more importantly, is that about 90% of the cash is held by the insurance companies, so that cash is largely restricted for claims payment.

    I do believe that the float has value, and think that completely dismissing it understates the Berkshire business model. I think a good market metric is to borrow the deposit premium metric from banks. If you expect forward float to be $47 billion, and you consider that similar to bank deposits, adding 10% for float seems reasonable.

    Taking 10% of your forward float of $47 billion and adding your $114 billion of 15X operating earnings + $42 billion in investments results in IV of $160.7 billion or $104,486 per share. Using Buffett's discount rate of 6.5% gives me a NPV of $92,121, implying the current price is about a 9% discount to IV. Not bad, but not great.

    Anyway, I appreciate you bringing up Berkshire, especially a week before Berkfest begins. Wonder if they'll now be serving Bud at the Borsheim's cocktail hour next week? I am looking forward to the Q&A next Saturday.

    David

    Subjectrecent developments
    Entry05/01/2005 12:19 PM
    Memberdanarb860
    Buffett was recently allowed to testify NOT under oath... Buffett's testimony may have played a role in Greenberg's outster. Does anybody else find it odd that Buffett was so complimentary of Greenberg yesterday at the BRK annual mtg?.. I don't think it is a leap of faith that Greenberg is now gunning for Buffett and yesterday's compliments reflect that Buffett believes that that may be the case? Maybe it all just blows over for Berkshire.. but?

    SubjectThoughts on Super Catastrophes
    Entry09/21/2005 01:00 PM
    Memberelan19
    Nish (or anyone else) - I'd like to hear if you've expanded or revised your thoughts about supercatastrophes and thus your valuation of BRK (especially the value of the float). In a prior post, I posed the question:

    "What is the maximum possible payout that could occur in a single year if every existing supercat policy was triggered at its maximum level? Or if this is a ridiculous possibility, what if 1/10 of the policies were triggered?"

    Your reply was:

    "2. All their supercat and other policies are capped. In virtually all cases payout is well under $1 Billion. Very very few are over $1-2 Billion. With mega-catatrosphes (WTC in 2001), the hit was about $2 Billion (but it did not reduce float by $2 Billion as much of it will take years to be paid out).

    4. So, even if a few events generate hits of over $1 Billion
    each, I can't envision a hit in any single year over $5 Billion. It BRK paid out $5 Billion, the insurance industry is likely paying out about $200 Billion. The total industry-wide float is about $400 Billion. There has never been a $200 Billion hit to the industry in a single year. Could happen, but the odds are very low and BRK would likely survive if we survive."

    I am looking at BRK again as I think they may have better pricing power going forward. But I still wonder about this super catastrophe thing. Just from one event, Hurricane Katrina, BRK just let the public know that 3%-5% of industry losses should be expected for this (or any) such event. If Katrina comes to $50-$60b, that's perhaps $2.5 billion. With Rita on it's way to Galveston, TX, that could be another $2.5 billion or more. All this from just 2 big events. It's pretty easy to envision 2005 as being an earnings hit of over $5 billion (but not immediately to cash, as it would get paid out over years).

    Given that most policies are capped at $1 billion, the implication here is that multiple policies were triggered (presumably they reinsured a number of insurance companies). So one part of the standard BRK dogma is suspect - that there is little correlation between policies.

    What's even scarier is that some states are trying to insist that insurers must pay for flood damage from Katrina even if this was excluded in the policies - if successful, this could greatly increase the hit to the industry and BRK's liability - and sets a precedent for such things to occur in the future.

    How do you think about these things? Do you worry that global warming could cause the number of catrastrophes to change dramatically? Hurricane frequency over the past 30 years was below the last 100 year average - what happens if hurrican frequency for the next 30 years goes above the last 100 year average? How can you forecast government action which increases insurer liability after the fact? Will future price increases make up for all this?

    Just curious to hear your thinking. I've always assumed that one year, a few catastrophes like this might occur. I also assumed (incorrectly, it turns out, at least so far) that the stock price would get clobbered - and so best to wait for a year full of catastrophes to buy the stock.

    SubjectThanks
    Entry09/22/2005 02:43 PM
    Memberelan19
    Thanks for your thoughts - one year contracts are a good thing as they can indeed walk away from the business if risks are increasing and they don't get the pricing they need to make it work.

    Subjectyour comments
    Entry03/06/2006 07:49 PM
    Memberdanarb860
    I don't really understand exactly what your conclusion is. There are a few things that must be kept in mind about float. I am not sure to what extent reserves are discounted at BRK, but many P&C companies discount their reserves. If BRK has done this (and they do not discount the assets)... well one can't ignore this. #2, I think assuming return of 10% on float is extremely aggressive. 10% after tax implies roughly 15% pre-tax on all components of float (debt, equity, etc.). I doubt that even the great Warren Buffett is going to do that going forward, and that assumes that the cost of float = 0. If it is negative, then that has to be made up. Finally, if you are putting such a value on the float, I couldn't tell from your write-up whether or not you were backing this out of operating earnings as the segment earnings do include income on the float, and if you are going to value the float separately, then (and you may be doing this) operating results on which one puts a multiple must back out the dividend and interest income.

    One other note: Berkshire made many excellent distressed and loan investments in 2000-2002. A huge piece of profits in 2005 was realized gains, and I think (although not sure) that much of these gains were profits taken on the investements made in the earlier years. These will not so easily recur until the next blood bath in some sector (which Buffet will undoubtedly take advantage).

    Subjectre: your comments
    Entry03/07/2006 07:56 AM
    Memberconway968
    Danarb:
    Thanks for your thoughts. I realize the insurance reserves are discounted - correct me if I am wrong, but BRK includes this in their calculation of underwriting profit. Even after that, it appears they take in on average $1B more in premiums then they pay out in costs (including amortization).

    My point was probably a little convoluted, but it can be summarized as follows: cash and investments should be considered to have a higher return on Berkshire's balance sheet then they do on other balance sheets. For instance, though I don't own them, I believe BUD, WMT, WFC, etc have a higher expected real return than the market and lower risk - I believe they are underpriced. As such, it presents a dilemma as to whether to mark them at face on Berkshire's balance sheet. To get around this, I prefer to assume they are an operating asset that grows in value at 10% - 12% per year (or equivalently creates that amount in pre-tax earnings). Similarly, the cash isn't just cash - it is cash plus an option for Buffett to put it in something else. Surely this has value above just the value of cash. Nish handled this one way by saying "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". I think it is just as easy to assume a normalized return on this cash that is higher than the actual return, based on an estimate of Buffett's average spread on return on the market. If we say it is 5% (historical average is higher), then the cash yield is about 10% pre-tax (I made it unclear in my other comments whether I was talking pre-tax or post-tax). I'm comfortable calling it 10% bc I believe if he does find suitable opportunities in equities they are likely to be in the 15% return neighborhood (and likely low risk) and if he doesn't, he'll hold cash at 5%.

    Using 10% on cash and investments ($114B) and adding to the $5.5B or so of operating earnings on all the other businesses (including underwriting profits, but not including investment income or trading profits), you get operating earnings of $16.9B. At a 35% tax rate that drops to $11B after-tax normalized earnings. This yields Berkshire trading at about 12x earnings. Since Berkshire seems to have a real dollar earnings stream that grows at a slight premium to inflation and that is very diversified (and thus stable), I think 20x+ is a more appropriate multiple. On top of that, at this price you own Berkshire at a very modest premium to its cash balance. Seems like the risk/reward is good.

    The big assumption/unproven idea here is obviously giving cash a return at a premium to its actual current returns. I think this is done all the time in valuing other types of assets, but I realize this is unorthodox with cash. Also please note I have yet to do a sum-of-the-parts analysis of the operating earnings of the wholly owned businesses, so I'm not going to stand by the $5.5B numbers as being exactly right. I welcome thoughts on this, and I imagine it is a somewhat controversial way to look at things.
      Back to top