Berkshire Hathaway (BRK.B) Valuation

Berkshire Hathaway probably needs no introduction. It is one of the largest conglomerates in the world, and a holding company / investment vehicle for Warren Buffett, arguably the most famous investor of all-time. It is also a favorite holding of "value" investors, whose devotions to Buffett's philosophies sometimes border on the cult-like.

Although I've been following BRK for a while, I haven't done a proper valuation of the company because a) there are already countless valuations out there from people who know the company far better than I ever will and b) the various businesses are complex and difficult to understand as a whole. However, I recently read The Warren Buffett Way and The Warren Buffett Portfolio, by Robert Hagstrom, and thought it would be a fun exercise to value BRK using the "Tenets of the Warren Buffett Way" described in the books:

Tenets of the Warren Buffett Way

Business Tenets

1) Is the business simple and understandable?

Not really. Berkshire owns 71 different operating subsidiaries and dozens of minority holdings in various companies.

While it is true that a majority of income is derived from a handful of larger subsidiaries, accurate analysis of even the largest subsidiaries seems like it would be a difficult task for someone who is not simultaneously an expert in a variety of wildly different fields (Railroads, Energy, Metal Components, Insurance, etc). Commendably, Buffett has tried to simplify understanding of each business line (see his "grove" analogy in the 2018 annual report) - but the reality is that this is a complex conglomerate with many disparate, moving parts.

For example, one large business line insures against "catastrophic" loss - i.e. hurricanes, natural disasters, etc. In 2017, Berkshire suffered a $2.8B loss, partly due to Hurricane Harvey. Hurricane Harvey seemingly (and materially) changed the odds of a catastrophic event occurring overnight ("What used to be a 500-year event has become a 50- or 100-year event."), which doesn't speak much for the accuracy of previous predictive models. A recently published study says that "statistically based risk assessment suffers from short records of often poor quality, and in the case of meteorological hazards, from the fact that the underlying climate is changing." I certainly don't know the answers, but given the inherent complexities of weather, climate, and climate change - exacerbated by attempting to extrapolate inherently rare events from "short records of poor quality" - I doubt anyone else does either.

Buffett's reasoning for individual equity investments is also often opaque. Large investments are now being made by other "fellows in the office that manage money", for whom we have even less insight into investment philosophy. Material acquisitions (like Precision Castparts, which was purchased for $37B) lack segmented reporting, which makes their performance difficult to assess. This lack of transparency can lead to unexpected large write-downs and seemingly hypocritical holdings based on previously stated investment rationales.

Essentially, you are putting your trust in Buffett that things are as he says they are. Given his track record, this is probably a safe bet to take - but it doesn't make the business "simple and understandable."

2) Does the business have a consistent operating history?

Yes. Berkshire has one of the longest, most impressive, and remarkable track records in corporate history. Revenue and earnings have steadily increased since inception in 1965, resulting in a compounded annual gain in market value per share of 20.5% from 1965 - 2018. If you had invested $100 in Berkshire in 1965, you would have had over $2MM at the end 2018, compared to only $14,830 had you invested in the S&P 500 index.

3) Does the business have favorable long-term prospects?

Revenue growth has leveled off in the past decade; material growth has become harder to come by the larger Berkshire gets.

Most business lines are relatively unexciting but necessary, and unlikely to grow more slowly (or much more quickly) than US GDP.

The wildcard here is a large acquisition or investment that materially changes the growth trajectory of the business, but given Berkshire's current size this will be difficult. And the performances of Berkshire's more recent purchases (Kraft Heinz, Precision Castparts) have been less than encouraging.

Management Tenets

4) Is management rational?

This is hard to assess, if only because Berkshire has been sitting on an ever increasing cash pile, currently $128B, which arguably should be returned to shareholders since it isn't being put to productive use. But I think it makes sense to give Warren Buffett the benefit of the doubt, here.

5) Is management candid with its shareholders?

Again, somewhat mixed. Berkshire's annual reports are well-written and the annual meetings are open to all shareholders, but Buffet's famed "folksiness" disarms his fans and arguably shields him from answering tougher questions about the business. Many of his answers are evasive - something I noticed during my attendance at the annual meeting in 2019, but also highlighted in this video from a long-time analyst:

...I think there's a big difference between what you see on stage and in real life. I think the biggest challenge for me as an analyst asking questions is that I know Warren will evade my question if he can...

Berkshire has also not been forthcoming with succession plans, a seemingly important issue for two managers aged 89 and 96, and for a business that is largely dependent on the reputation of Buffett (both in his ability to get access to favorable deals, and in the trust he engenders in shareholders, who almost blindly trust his assessments of the business).

6) Does management resist the institutional imperative?

Yes. The book describes the institutional imperative as "the lemming-like tendency of corporate managers to imitate the behavior of others, no matter how silly or irrational it may be." Buffett and Munger have long been champions of commonsense business fundamentals, and their practicality resonates with my business experience.

Ironically, Berkshire has arguably constructed its own "internal" institutional imperative, in the sense that its shareholders have the "lemming-like" tendency to take everything Buffett says as gospel, "no matter how silly or irrational it may be" - resulting in a form of regulatory capture. This is purely a subjective assessment on my part, primarily from my observations at an annual shareholder meeting, but it was a sentiment shared by a few other "cautious fans" of Berkshire.

Financial Tenets

7) Focus on return on equity (ROE), not earnings per share

Berkshire's ROE has averaged 7.5% over the past three decades:

This appears to be significantly below the average ROE of the S&P 500 as a whole (13.7%) over a similar period.

8) Calculate "owner earnings"

Buffett defines "owner earnings" as "a company's net income plus depreciation, depletion, and amortization, less the amount of capital expenditures and any working capital that might be needed." Basically, how much money is left over in the owners' pockets after all is said and done?

Because of various accounting rules, owner earnings may not match accounting earnings, but owner earnings arguably give a better picture of the business.

Damodaran's Free Cash Flow To Firm (FCFF) metric in his valuation models captures these subtleties for the most part (through "reinvestment rate"), and some of Berkshire's older annual reports describe owner earnings quite thoroughly, so I won't go into more detail here.

9) Look for companies with high profit margins

High profit margins may hint at a) an economic moat that allows a business to charge more than its competitors, because no substitute is readily available and b) a culture that is vigilant in controlling costs - both of which may provide an enduring advantage.

Berkshire does not appear to have outsized margins. For example, based on my calculations (see valuation spreadsheet below), its industrial / non-insurance operating margins have averaged 10.42% over the past 15 years, which is within one standard deviation of the base rate average of 9% for all industrials.

10) For every dollar retained, make sure the company has created at least one dollar of market value

Buffett "proceeds in the belief that if he has selected a company with favorable long-term economic prospects, run by able and shareholder-oriented managers, the proof will be reflected in the increased market value of the company." In particular, if a company "employs retained earnings non-productively over an extended, eventually the market (justifiably) will price the share of the company lower."

From the beginning of 2010 to the end of Q3 2019, Berkshire has increased its retained earnings from $131B to $348B, an increase of $217B.

During this same period of time, Berkshire's market cap has increased from $153B to $509B, an increase of $356B.

Thus, for every dollar retained Berkshire has generated $1.64 of market value, a positive result.

Market Tenets

11) What is the value of the business?

Like I mentioned before, Berkshire has been a challenging company for me to value. The best method I could come up with is to break down Berkshire into three parts:

  1. Non-insurance
  2. Insurance
  3. Dividends / Investment income

And value the growth, operating margins, and cash flows for each of those parts separately. Given the long operating histories of each "business line", I've used average operating margins, reinvestment rates, etc - with the expectation that the future will not be much different from the past. As Berkshire gets larger, I also assume that revenue growth will be slower than in the past, ultimately constrained by US GDP growth.

These operating metrics are weighted according to the revenue of each division, resulting in a blended operating margin and growth rate for the conglomerate as a whole.

A large part of the value of Berkshire lies in its stock holdings. To value this piece, I simply took the market value of the investments as reported in the balance sheet, and reduced it by the taxes that would likely result if Berkshire were to sell these investments.

The full valuation and relevant assumptions can be found here:

[PUBLIC 2019.01.17] BRK.B Valuation Model
Assumptions Segment Operating Metrics Non-Insurance (Sales and service; Railroad, utilities and energy; Leasing) 2004,2005,2006,2007,2008,2009,2010,2011,2012,2013,2014,2015,2016,2017,2018,14-Year CAGR,10-Year CAGR Revenue,$47,916,$51,455,$68,428,$76,847,$85,017,$77,695,$97,238,$107,259,$119,947,...

12) Can the business be purchased at the significant discount to its value?

Based on the calculations above, I estimate the value of BRK.B at $252 / share, which is only slightly above its current share price of $230, and not a "significant" discount to fair value.

Summary

Looking objectively at the checklist above, the results are mixed. The strongest thing Berkshire has going for it is its "consistent operating history", but continued progress will likely be threatened by its sheer size and by the company's dependence on an aging Warren Buffett. Given these uncertainties, I don't think I'd be a purchaser of the stock unless it traded at a more significant discount (i.e. -20% to -30%) to fair value.

Disclaimer: While my analysis of Berkshire as a current investment opportunity is not favorable, I should emphasize that Warren Buffett is one of my heroes, and I've learned more about investing from his writings than from any other source. The fact that he has been both a successful operator of businesses, as well as a successful investor, is a model for my own aspirations. It is unlikely that I'd be attempting to invest full-time (and writing about it) if it weren't for his enormous influence. So even though I am not a current shareholder - thanks, Mr. Buffett!

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