Berkshire Hathaway is a bit of an anomaly when it comes to conducting a valuation of the business. On the one hand, it is an incredibly complex, and often times secretive, operation where getting exact details of quantitative data can be incredibly difficult. For example, if you peruse the annual reports or 10Ks, the income statement will be presented in a very general sense but not provide details on each individual business unit. However, on the other hand, Warren Buffett has dropped a ton of hints along the way in his annual letters on what he believes is the intrinsic value of the business. Seeing as the most recent annual report has recently come out, Berkshire is on my mind. So let me give you an introduction on how to do a quick and dirty calculation to figure out the intrinsic value of Berkshire Hathaway.
Ok, I’m going to keep this brief as it is a gorgeous day outside and I don’t want to be sitting in this dark room like a troll hunched over a computer typing the beautiful day away. (Ok I lied, I didn’t end up finishing this after I wrote that previous sentence, as I hit save half way through and headed outdoors)
Warren Buffett stated in the 2013 annual report:
“As I’ve long told you, Berkshire’s intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That’s why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. We did not purchase shares during 2013, however, because the stock price did not descend to the 120% level. If it does, we will be aggressive.”
This tells you that there is a correlation between book value and intrinsic value when it comes to Berkshire. Book value is a rough way to gauge the intrinsic value of the company. Buffett even states this in the Berkshire Owner’s Manual:
“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.
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The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this value.
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Meanwhile, we regularly report our per-share book value, an easily calculable number, though one of limited use. The limitations do not arise from our holdings of marketable securities, which are carried on our books at their current prices. Rather the inadequacies of book value have to do with the companies we control, whose values as stated on our books may be far different from their intrinsic values… our book value far understates Berkshire’s intrinsic value, a point true because many of the businesses we control are worth much more than their carrying value.
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Inadequate though they are in telling the story, we give you Berkshire’s book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire’s intrinsic value. In other words, the percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value.”
Now, we know 3 things:
- Book Value far understates the Intrinsic Value of Berkshire Hathaway.
- When Berkshire is priced <1.2 Book Value, Buffett (a stickler for great deals) will buy back stock aggressively.
- Changes in Book Value year-to-year provides a “reasonably close” estimate of the changes in intrinsic value.
Berkshire’s book value since 1965 has grown at 19.4% CAGR. However, this isn’t the most accurate way to gauge what Berkshire might realistically grow book value into the future as it is now a giant and can no longer compound at the levels of it’s more nimbler and younger days (like I pointed out in the comparison between Coke and Treasury bonds).
We can look at the previous 10 years of book value growth which saw book value grow at 10.13% CAGR. The previous 5 years saw 8.83% CAGR.
Mary Buffett, in the book Buffettology, explains that Berkshire typically trades between 1.0 – 2.0 book value. It’s a close enough approximation for our exercise. Let’s run with it.
Now, with the information we have, let’s make a series of assumptions:
- Book Value will grow at a pedestrian (compared to the 19.4% achieved since 1965) 10% for the next 10 years.
- Berkshire will trade right in between 1.0 and 2.0 times book value at 1.5 book value in 10 years.
- We are looking for a 10% return on investment over the next 10 years.
Remember the simple discount cash flow example I used on this very blog? If you don’t, go refresh yourself. I’ll be here waiting. I promise.
Alright, so with these 3 assumptions in mind, we can do a simple, quick and dirty, back-of-the-envelope calculation on valuing Berkshire using the formulas for:
- Future Value of a Single Sum = FV=PV(1+i)^n
- Present Value of a Single Sum = PV=FV/(1+i)^n
In the most recent annual report, book value is reported as $97.46 per B share. Therefore, plugging in the future value of a single sum formula, we would calculate:
FV = 97.46 (1+0.10)^10 = 252.79
252.79 x 1.5 = 379.18
Now, since we are looking for a 10% return on our investment over 10 years, we would plug 379.18 into the present value of a single sum formula:
PV = 379.18 / (1+0.10)^10 = 146.19
What you are doing with these 2 formulas is to first calculate what the current book value of Berkshire Hathaway will grow to in 10 years at a 10% growth rate. The formula shows you that the figure would be $252.79. Now, since we used the assumption that Berkshire will trade at 1.5 times book value, we multiplied $252.79 times 1.5 which gave us $379.18.
$379.18 is what Berkshire Hathaway B shares would roughly trade at if book value grew at 10% for 10 years and traded at 1.5 times book value. Now, we demanded a 10% return on our investment in Berkshire over 10 years. So what we did was take $379.18 and discount it back to the present, which gave us a value of $146.19. This value, $146.19, represents the maximum we could pay for one B share if we wanted a 10% return on our investment. It is very similar to the example I used of “valuing” this very blog.
Now, this is an oversimplification of valuing Berkshire Hathaway for sure and it contains various assumptions and projections into the future, none of which are guaranteed to be true. So why would I write this incredibly long post on doing a simple technique to value this company?
Well, because I want you, the reader, to think critically about investments. Read through the annual reports and 10Ks of the businesses you are interested in taking ownership in. Study these primary source materials. Gather the data. Analyze, inquire, and think.
The pieces are all out there – you just need to put it all together.