There are numerous approaches for coming up with an intrinsic value estimate for any business. In the case of Berkshire Hathaway, many investors look at metrics such as multiples of book value, multiples of earnings, and float based models. I personally favor a float based model and wrote about this in detail last weekend. My view is that any valuation of Berkshire that does not examine the cash flow generating power of float will undervalue the intrinsic value of the business.
While the float based model may produce the most accurate assessment of intrinsic value, it is often useful to examine the results of using different valuation techniques as well. In this post, I will discuss the “two column” approach that many believe has an informal “endorsement” from Warren Buffett.
In Buffett’s letters to shareholders, he usually discusses “yardsticks” for measuring Berkshire’s value. For example, here are his comments from the letter just published last week:
Berkshire has two major areas of value. The first is our investments: stocks, bonds and cash equivalents. At yearend those totaled $122 billion (not counting the investments held by our finance and utility operations, which we assign to our second bucket of value). About $58.5 billion of that total is funded by our insurance float.
Berkshire’s second component of value is earnings that come from sources other than investments and insurance. These earnings are delivered by our 67 non-insurance companies, itemized on page 96. We exclude our insurance earnings from this calculation because the value of our insurance operation comes from the investable funds it generates, and we have already included this factor in our first bucket.
Although Buffett does not state a specific formula for calculating Berkshire’s intrinsic value based on these two “areas of value”, his comments elsewhere on the value of cost free float lead me to believe that he considers the investments per share to be directly additive to Berkshire’s intrinsic value. This is “Column One”: The value of Berkshire’s investments. “Column Two” represents the value of Berkshire’s non insurance subsidiaries.
Column One: Investments
I estimate that Berkshire’s investments have probably declined by $18 billion based on my analysis of the 13F report that disclosed Berkshire’s positions as of December 31, 2008, and assuming that most positions remained unchanged so far in 2009. Berkshire investments per share are probably around $104 Billion based on current quotes.
Column Two: Non Insurance Subsidiaries
As I estimated in my analysis of the non-insurance subsidiaries, these businesses had approximately $4 billion in after tax net income in 2008, if one backs out the one time gains at Mid American due to the Constellation Energy gains and break up fee. In my analysis, I used a 10x earnings multiple of net income which I believe to be very conservative based on recession level earnings. This would result in a valuation of the non insurance subsidiaries of around $40 billion.
Two Column Valuation Results
Looking at this simple valuation model, we can estimate that Berkshire should have a valuation of at least $144 billion if one simply takes investments per share and then adds the value of the non insurance subsidiaries using a conservative multiple. Berkshire’s market capitalization today (March 5, 2009) stands at approximately $112 billion. This is only $8 billion above my estimate of Berkshire’s investments per share. It would appear that based on this model, the market is placing a multiple of two times after tax earnings on the non insurance subsidiaries.
The point of this exercise isn’t to suggest that Berkshire’s intrinsic value is $144 billion, or roughly $93,000 per A share. My view is that true intrinsic value is far higher. The point is that at Berkshire’s current quote of $72,400, the market is assigning a multiple of just two times net income to the operating subsidiaries.
Markets can do irrational things in the short run, but in the long run value is what counts. As Ben Graham said, in the short run, the stock market is a voting machine but in the long run it is a weighing machine. These are words of wisdom to keep in mind in today’s market environment. To be sure, Berkshire’s investments have taken a hit in 2009. However, the decline in Berkshire’s quotation has been disproportionate to any decline in business intrinsic value.