April 25, 2015

Morningstar Says Berkshire Hathaway’s Intrinsic Value Is $89 Per Class B Share. I Think They’re Wrong.

I’ve told you in the past that Berkshire Hathaway appears to be trading at the lowest valuation in nearly a decade.  Recently, Morningstar revised its intrinsic value estimate for the Berkshire Hathaway Class B shares, stating they believe the stock has an intrinsic value of $89 per share (equal to $133,500 per Class A share since it takes 1,500 Class B shares to equal a single Class A share).  

I find this interesting for several reasons.  First, Morningstar’s intrinsic value calculations are often reasonable, in my opinion.  On more than one occasion, we’ve been within a single percentage point after I had valued a firm and then cross checked third-party estimates as part of the process to see if there were major disagreements.  But in this case, I just think they’re wrong.  

To help you visualize how they are thinking about Berkshire Hathaway’s intrinsic value, I created this pie chart that shows what the Morningstar analysts believe are the per share intrinsic value of each major division in the company.  Consolidated, they total to the estimate of $89 per share.  

It is important to realize that the following chart shows dollars not percentage.  In the latter terms, Morningstar is saying they believe Berkshire Hathaway’s intrinsic value is roughly 55% insurance, 4.5% financial, 22.5% railroad, energy, and utility, and 18% manufacturing, service, and retail.  But we’ll get into the specifics in a moment.

Berkshire Hathaway Intrinsic Value Estimate

I Believe the Morningstar Intrinsic Value Estimate for Berkshire Hathaway Is Incorrect

What do I think?  I think they are wrong.  But I think Morningstar is erring on the side of being too cautious, which is 1.) normally not my problem … usually, I find myself coming up with figures below the estimates of other analysts, not above and 2.) it’s a good thing, in my opinion, because the world would be a better place for investors if folks undershot their equity valuations, avoiding a lot of pain and misery for the inexperienced and leveraged.

Berkshire Hathaway Intrinsic Value and Annual ReportI understand why Morningstar believes its analysis of intrinsic value is correct.  The simplest way to value Berkshire Hathaway, which is unlike any other firm I’ve ever studied, is to take the shareholder equity of $162,934,000,000 and add it to the $65,832,000,000 in “float”, which is money the company holds on behalf of policyholders and gets to invest but doesn’t own, arriving at an intrinsic value of $228,766,000,000.  The firm has the equivalent of 2,472,771,695 Class B shares outstanding, indicating an intrinsic value of $92.51 per share.

But I think that’s wrong.  Berkshire Hathaway has been under Warren Buffett’s control for almost a half century.  Many of the businesses bought in the early years, such as See’s Candy Shops, are carried at book values far below what they would be worth if sold or spun off to stockholders.  Even GEICO, which was fully consolidated back in the 1990’s, has grown in value considerably over its carrying book value.  

My Estimate of Berkshire Hathaway’s Intrinsic Value

I’m not going to tell you exactly what I think the intrinsic value of Berkshire Hathaway is, but I will say that at present conditions, I’m pegging it somewhere between $100 and $115 per share, with a maximum theoretical value of $132 per share.  That is the upper bounds of where I think a reasonable investor can go, and given my personal value orientation, I probably wouldn’t be there with my own checkbook since I’m likely to find better deals elsewhere.  The $100 to $115 range seems much more reasonable looking at the firm from the ground-up than $89 does.  

Interestingly enough, the recent Berkshire Hathaway share repurchase announcement pegs the upper threshold of buybacks at 110% of book value, or $72/$73 per share.  Going back to the old Benjamin Graham rule to demand a discount-to-intrinsic value of 1/3, meaning you only pay 2/3 of what a company is worth to build in a margin-of-safety, the implied intrinsic value would be $108 per share.  Take that for what it is worth, if anything.

Intrinsic Value Is Not Static … It Can Grow or Decrease With Time

Furthermore, intrinsic value grows with time when you own excellent businesses.  Let’s presume that Berkshire Hathaway becomes perfectly mediocre and generates the average return on equity for large stocks, 11% per annum.  If the intrinsic value is, say, $108 per share, that would put per share intrinsic value at $306 or so 10 years from now, relative to a per share book value of roughly $187, for a multiple of just above 1.6x book prior to any share repurchases or cash dividends.  The stock currently trades at $73.17 per share.  It’s that differential beween what I think is a reasonably projected intrinsic value and the current market price that piques my interest.

In any case, regardless of which analysis one believes, the stock would appear to be trading for far less than intrinsic value.  Add in the evidence demonstrated by Warren Buffett actually repurchasing his own shares and that seems to be a defensible conclusion.

That is one of the reasons I’m a net buyer for one of the few portfolios I discuss on the site, the KRIP.  I’ve been buying all year, and will continue to buy as long as the market price seems attractive relative to intrinsic value.  That is also why I simply wouldn’t care if the price fell by 50% tomorrow.  As long as I believe the financial data indicates intrinsic value remains intact, market value is of no concern to me except to the extent I can take advantage of it to buy more ownership.  Stock prices are, have always been, and will always be, completely unpredictable and volatile in the short-term.  It’s the nature of the game.  

I do believe that, over time, the breakdown of intrinsic value at Berkshire Hathaway will shift so that insurance, while remaining an enormously important part of the conglomerate’s overall earnings, will become relatively smaller as other operating companies are added to the mix.  

Note: This is not a stock recommendation.  I am not a financial adviser, I have no fiduciary responsibility to you, and any action you take or fail to take is completely your responsibility.  Be an adult and do your own thinking.  Read annual reports for yourself, only buy what you understand, never risk money you can’t afford to lose, and stop looking for stock tips.  Find great businesses to own for the long-run, pay a fair price relative to earnings and assets, and focus on letting time and compounding do the heavy lifting for you.

  • Gilvus

    S&P’s report (current as of Oct. 1) gives a qualitative risk assessment of “high”, citing David Sokol’s Lubrizol incident and Warren Buffett’s age as major offsets to the company’s positive factors. Interestingly enough, there isn’t a intrinsic value calculation with this report.

    Any thoughts?

    • Joshua Kennon

      What @timmerjames:disqus said.

  • James

    I know you are looking for Joshua’s take but here’s my take on S&P….those are two weak factors to rate the risk at “high”.   If you read the quarterly reports of any company there’s a section on risks and if an investor actually read those things nobody would ever invest in stocks.

    If those two things are the reason for a “high risk” rating then what kind of risk rating do they give to a Goldman Sachs or Citigroup or Apple?

    I don’t really see much risk to the sokol incident; I’m not a lawyer but I don’t think the company did anything illegal.

    As for buffett’s age, I think the biggest factor is getting sweetheart deals like the Goldman/GE/BAC preferred stock deals.  Let’s face it – if Warren is gone, I don’t think Berkshire gets the same deal.

    With that said, from what I read, $1 billion in cash is pouring into headquarters from their operating companies and investments each and every month for buffett to invest.  This isn’t going to stop if Warren is gone or there is some kind of penalty for the sokol incident. 

    I don’t think those two things are a reason not to invest.  But one will need to watch how the two new investment managers invest that $1 billion/month once buffett is gone.  Hopefully those two new guys share the same values on investing as buffett.

    The collection and value of businesses berkshire has does not have anything whatsoever to do with either factor they cite.

    • Gilvus

      Thanks for your reply (and Joshua’s feedback). I’ve seen the risk sections; it’s like management lists any calamity short of a terrorist strike or act of God. I guess the lesson learned here is I should continue to do my own thinking, regardless of what professional analysts say.

    • http://www.kapitalust.com/ Steve

      Don’t mean to necro-bump an ancient thread, but I wonder if Berkshire would still be able to secure sweetheart deals like the Goldman/GE/BAC in a 2008-esque crisis where liquidity freezes up and Berkshire remains the only game in town with billions on hand to lend out on tilted conditions?

      While WB has a big influence on these types of deals, in the end, wouldn’t the money do the talking (and securing sweetheart deals) in the face of a crisis? Of course that assumes that the successor of Berkshire will be as competent as WB.

      But at the end of the day, if BRK has billions of cash on hand and other companies don’t, these companies are not in a position to negotiate favorable terms if they need the money. Thoughts?