The Next Ten Years
Board: Berkshire Hathaway
I find it useful to make simple projections regarding Berkshire over the next decade in an attempt to understand the range of plausible investment results given the current stock price.
At the current price, Berkshire is trading for roughly 1.4x stated book value at 3/31/2013 (although the current P/B is definitely lower due to equity portfolio gains and operating income quarter-to-date).
I created a simple matrix that attempts to project Berkshire's price per A share in ten years based on two variables: Annual growth in book value per share and the terminal price/book ratio. For example, if book value per share grows at a 9% annualized pace and the terminal P/B remains at 1.4x, we can expect Berkshire's shares to trade at almost $400,000 ten years from now. Not surprisingly, this results in a 9% return to someone buying Berkshire shares today because the P/B ratio would be the same at the time of purchase and at the end of the forecast period.
The following matrix shows the range of potential prices of Berkshire in ten years based on a range of annualized book value/share gains between 6% and 12% and a range of terminal P/B between 0.9x and 1.8x book value:
In terms of looking at the plausible outcomes, I would argue that the terminal P/B will correlate with book value per share growth over time. In other words, if book value per share grows at only 6% annualized, I view a terminal P/B of 1.1 or 1.2x to be more likely than 1.7x or 1.8x. Similarly, if book value per share grows at 12% annualized, I would view a terminal P/B of 1.6x or 1.7x to be more plausible than a terminal P/B of 0.9x or 1.0x. The market will eventually assign a higher P/B to Berkshire if compounded gains in BV/share are higher, and a lower P/B if compounded gains in BV are lower.
The next matrix shows the annualized rate of return shareholders can expect if they purchase Berkshire shares today at $168,600 and we see various combinations of BV growth and terminal P/B ratios:
If you look at the column with a terminal P/B of 1.4, you will see that returns to shareholders will exactly match book value growth. This makes sense given that with the starting and terminal P/B the same, the only gains to shareholders will be derived from actual growth in book value.
The green cells in the matrix are those that show an expected annualized return of ten percent or greater which is an arbitrary hurdle rate I selected (every investor will probably have a different hurdle rate). In this case, the investor is saying that he demands a 10% return to commit funds. Therefore, the scenarios that are acceptable are those shaded in green. The white cells will be considered unacceptable. Of the seventy cells, only 23 are green.
As with the first matrix, certain cells are more plausible than others. The idea of Berkshire compounding BV/share at 12% but ending with a 0.9x P/B ratio seems ridiculous to me (but maybe not to the guys at Loews who have delivered such returns only to see their stock languish below book ... ). And the idea of Berkshire compounding book at only 6% but ending with a 1.8x P/B seems unlikely as well.
If someone wants 10% annualized from Berkshire, it is necessary to either believe that BV/share can grow at that rate OR expect P/B expansion if growth in BV/share falls short of 10%.
I find the matrix helpful when looking at Berkshire and considering the long term prospects for my investment. I personally have a goal of compounding my money at 15% annualized if I'm going to be putting time and energy into the process. I do not see Berkshire providing 15% annualized from here in ANY of the plausible scenarios I see for the company over the next ten years. However, I do see 10% annualized as quite plausible and simply holding Berkshire requires zero effort (other than perhaps 20 hours/year reading and analyzing each of the quarterly filings and the annual report).
For the majority of passive investors who are familiar and comfortable with Berkshire, I think that the company is more likely than not to outpace the S&P 500 by a "modest" amount over the next decade. I view Berkshire as my opportunity cost. Not only does another prospective investment require at least the prospect of 15% annualized but it comes at a cost of giving up what I consider a fairly safe 8-10% return from Berkshire. That is a MUCH higher bar than those who make investments based on the fact that the cash in their bank account is earnings nothing. People who make decisions where their perceived opportunity cost returns 0% will make different decisions than those who view 8-10% to be the opportunity cost.