Valuation

We value Berkshire the same way Buffett has indicated he does: value the investments (cash, bonds, and stocks) at market prices and then add the value of the operating businesses by putting a conservative multiple on their earnings.

How do we know this is how Buffett values Berkshire? He 's never come out and said it explicitly, but he 's given clues in some of his annual letters to shareholders:

Over the years we 've . . . attempt[ed] to increase our marketable investments in wonderful businesses, while simultaneously trying to buy similar businesses in their entirety.

—1995 Annual Letter

In our last two annual reports, we furnished you a table that Charlie and I believe is central to estimating Berkshire 's intrinsic value. In the updated version of that table, which follows, we trace our two key components of value. The first column lists our per-share ownership of investments (including cash and equivalents) and the second column shows our per-share earnings from Berkshire 's operating businesses before taxes and purchase-accounting adjustments, but after all interest and corporate expenses. The second column excludes all dividends, interest and capital gains that we realized from the investments presented in the first column.

—1997 Annual Letter

In effect, the columns show what Berkshire would look like were it split into two parts, with one entity holding our investments and the other operating all of our businesses and bearing all corporate costs.

—1997 Annual Letter

The cash and investments are easy to value, but what multiple should one use to value the operating businesses? Again, Buffett has provided clues over the years that lead us to believe he uses a 12 multiple of pretax earnings, equal to about an 18 P/E multiple, which until the recent market meltdown was roughly the market multiple. But it's no longer 18. With the cyclical P/E around 12, that translates into an 8 pretax multiple for the average large U.S. company. While we think Berkshire 's collection of businesses is far above average, let 's be conservative and use this.

One final (and somewhat controversial) adjustment: In his 2008 annual letter, Buffett said that Berkshire 's pretax earnings for the year were $3,921 per share (after minority interest). It is important to note that Buffett excludes the earnings of Berkshire 's insurance businesses, which earned an additional $1,807 per share. Given the unparalleled quality of these businesses, their consistent profitability, and Buffett 's prediction that they will continue to be profitable, we think these earnings should be included, which brings the total to $5,728 in pretax earnings per share last year. In light of the worsening recession in 2009 and a relatively benign year for super-cat insurance claims in 2008, to be conservative we estimate Berkshire 's pretax earnings at $5,000 per share in 2009.

Some would argue that we are double counting because we're including the float from Berkshire 's insurance operations in investments, plus we 're putting a multiple on the insurance earnings in valuing the operating businesses. Perhaps this is a little aggressive, but to exclude the earnings of Berkshire 's superior insurance operations and simply value them at book value is ridiculously conservative. In addition, we don't factor in any value for the fact that Berkshire 's float isn 't static, but instead has grown at a healthy rate over time and is likely to continue to do so. Finally, the 8 multiple we use is an estimate based on a blend of various businesses, some of which would have a higher multiple and some lower. Given that insurance companies traditionally trade at low multiples of earnings, if we removed Berkshire 's insurers from the calculation, one could argue that a 10 multiple would be more appropriate for the remaining businesses, which gets us to the same place (i.e., $5,000 per share times 8 is roughly equal to $3,921 times 10).

Regarding Berkshire 's investments, they were valued at $77,793 per share as of year-end 2008, but in the annual report Berkshire disclosed that book value had fallen "approximately $8 billion since the end of 2008." Let's assume this figure was through the third week of February and Berkshire 's stocks have fallen since then, so let's say investments are down by $12 billion after tax or $7,700 per share, which would bring the total to approximately $70,000 per share.

Now the math is easy: $70,000 + ($5,000 X 8) = $110,000. With the stock closing at $84,844 on March 10, 2009, Berkshire is trading at a 23 percent discount to its intrinsic value.

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  • pupa pisani
    How to value insurance companies as multiple of book value?
    8 years ago

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