Valuing Berkshire Hathaway
Board: Berkshire Hathaway
For a company that mostly invests its funds, valuation at book value makes a lot of sense. Even for other firms it's not a bad idea.
If we conservatively assume no unusual skill at investment, leverage will make no improvement, since the industry-wide weighted average return on capital must equal the industry-wide weighted average cost of capital. To get some more money to invest, the firm will have to pay a cost, and the conservative assumption is that those two will cancel and the returns will be about the same as they would have been without leverage. So, if you don't assume any unusual skill, earnings will vary as net assets, specifically the industry-wide average returns on invested assets.
The simplest approximation of the assets to invest is book value. Book has many flaws--notably handling of intangibles and inappropriate depreciation rates, and the lack of adjustment to assets of time as their and earnings power and probable market value change--but it is at least a single fixed number which isn't too bad an approximation provided the firm doesn't have a lot of its assets tied up in land.
But... What we're doing here is using book value as a proxy estimate of the amount of funds that the firm can invest on a long term basis without resorting to any leverage. For some firms, there might be better estimates.
This leads us to our usual notion that under very specific circumstances, the float of an insurance firm is as good as equity. If there is a very VERY good reason to expect zero cost of float averaged over time, and a very good reason to expect that the firm is a going concern, not in wind down, not shrinking, and likely able to maintain at least the same level of float for at least another couple of decades, then we can assume that the firm will get the returns on that float as it would on equity. Because of the necessity of keeping cash on hand and imperfections in those strict "evergreen capital" tests, I have suggested the idea that 70% of the float is as good as equity and the other 30% is a true liability the way that it is shown on the books because nothing much can be earned on it reliably or it might shrink a bit. We've had a number of interesting posts on the "book plus 70% of float" metric.
But, for Berkshire, we're missing one leg of the tripod. That's the deferred taxes. Though we usually just think of this as a liability that we'll probably have to pay some day, hoping to put that off for a while, we should think of that much as we think of the float. Some will get paid, but other new deferred tax liabilities will accrue. This is a firm with long investment horizons, and that's no coincidence. In all of the meaningful ways I can think of, deferred tax is as good as float. In the same way that float isn't quite as good as equity because of its restrictions and the fact that it might shrink a bit at some time, deferred tax should probably get a haircut too. Let's place the same 30% haircut on deferred tax, as well. There is no need to keep zero return cash on hand for it, but on the other hand a single major sale of a profitable position would cause a big drop.
Here are the figures for Berkshire's deferred tax in recent years. In recent years it has been reported as "income tax, principally deferred", so I have made the approximation that it is all deferred tax. Any error in that assumption won't change the trend.
[See Post for Tables]
It goes down sometimes when the market goes down because mark-to-market profits are smaller and therefore the notional tax on those notional profits changes. But overall, the trend is clear---there is a lot of deferred tax in place, it is growing, and it is not going away. The most important thing, back to the starting point: absent any leverage which could cost money, Berkshire earns money on those deferred taxes in the same way that it earns on float and equity.
So, I looked at a simple, easy to calculate valuation metric, just one step more complicated than book+float or book+.7*float. Simply calculate book + .7*float + .7*deferred tax. I believe it adds useful value to the question, since we have been ignoring one of the more important moving parts in Berkshire's outperformance. Here's how that metric has evolved in recent years.
[See Post for Tables]
It should be noted that there is no reason to expect this figure to match fair value---some sort of average multiple would be expected. However, as it turns out, the market price of Berkshire has mostly tracked this figure pretty closely, so it can be considered "as is". That corresponds to the conservative assumption that 100% of the available-for-investment assets will be deployed at average rates of return deserving of no premium, and that the investments will be of market-wide average quality, longevity and profitability. It also assumes that book value is "right", of course, in the sense that it's a good approximation of the conservative market value of the asset in question.
Lastly, since a word is worth but one-one-thousandth of a picture, here is a graph of the year-end b+.7f+.7dt figures above, intermittently, and the monthly average market prices of Berkshire's stock. Here is the graph in linear form.
Here is it in log form. This is more appropriate, since constant vertical gaps have constant meanings in terms of percentages of over/undervaluation, and a linear trend means a constant growth rate. But the data do get squished up a bit more, so I've shown both.
In both graphs, the final highlighted point is Friday's closing price rather than the average price for the last month.
The conclusion is pretty obvious that on this particular metric of value, which assumes no above-average investment skill on the part of management, the firm is unusually cheap right now compared to its history on that particular metric. On this metric, BRK is around 6% cheaper now than it was in March 2000 at $45,000.
It's not a perfect metric, since ultimately trend earnings power matters more than book value. Moody's hasn't had meaningful price-to-book value in the last decade, but has earned lots of money. However, it's easy to calculate, conservative, and makes some sense.