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You can't go back in time. If you could, investing in any number of cherry-picked companies would solve most people's present-day financial problems. Ah, if only.
The next best thing? Buying good companies at valuations even those with a time machine couldn't.
That's where Berkshire Hathaway (NYSE: BRK-B ) shares sit today.
How Berkshire should be valued is a regular matter of debate. It isn't a normal company, so some normal valuation metrics lack relevance. Many of Berkshire's investments generate no net income at all, yet still reward shareholders handsomely. Portfolio holdings such as Coca-Cola (NYSE: KO ) and Procter & Gamble (NYSE: PG ) generate only negligible returns on Berkshire's equity through dividend payments, yet have increased Berkshire's net worth by billions. It's that heavy reliance on capital application that makes income-based valuation metrics like the price-to-earnings ratio borderline irrelevant for Berkshire. Since the essence of owning Berkshire stock is to enjoy the compounded return of its assets, price-to-book value has always seemed like the most meaningful metric to me.
That's where things get interesting. Going off price-to-book value, Berkshire hasn't been this cheap in at least two decades:
Source: Capital IQ, a division of Standard & Poor's.
Berkshire's price-to-book ratio is actually lower now than it was in March 2009, when the global economy was coming apart at the seams and some (irrationally) wondered whether Berkshire's derivative bets might actually bankrupt the company.
And there's more relevance to today's valuation than simply calling it the lowest in years. After tumbling in recent weeks, Berkshire shares now barely hold any premium over book value, with a price-to-book ratio of just 1.1. A firm sneeze from current levels sends shares below book value for the first time in recent history.
That's where things get really interesting.
Consider what Buffett has said about the relationship between Berkshire's share price and book value: "Our book value far understates Berkshire's intrinsic value, a point true because many of the businesses we control are worth much more than their carrying value." Some Berkshire assets, Buffett has claimed, are "worth fifteen to twenty times the value at which they are carried on our books."
Take GEICO, a Berkshire insurance subsidiary. GEICO's intrinsic value is substantially higher than book value because of how goodwill is accounted for. Buffett laid it out in this year's letter to shareholders (emphasis mine):
When, in 1996, we bought the 50% of GEICO we didn't already own, it cost us about $2.3 billion. That price implied a value of $4.6 billion for 100%. GEICO then had tangible net worth of $1.9 billion.
The excess over tangible net worth of the implied value -- $2.7 billion -- was what we estimated GEICO's "goodwill" to be worth at that time. That goodwill represented the economic value of the policyholders who were then doing business with GEICO. In 1995, those customers had paid the company $2.8 billion in premiums. Consequently, we were valuing GEICO's customers at about 97% (2.7/2.8) of what they were annually paying the company. By industry standards, that was a very high price. But GEICO was no ordinary insurer: Because of the company's low costs, its policyholders were consistently profitable and unusually loyal.
Today, premium volume is $14.3 billion and growing. Yet we carry the goodwill of GEICO on our books at only $1.4 billion, an amount that will remain unchanged no matter how much the value of GEICO increases. (Under accounting rules, you write down the carrying value of goodwill if its economic value decreases, but leave it unchanged if economic value increases.) Using the 97%-of-premium-volume yardstick we applied to our 1996 purchase, the real value today of GEICO's economic goodwill is about $14 billion. And this value is likely to be much higher ten and twenty years from now. GEICO -- off to a strong start in 2011 -- is the gift that keeps giving.
GEICO might be an extreme example, but it's hardly unique. The cornerstone of Buffett's career has been acquiring high-quality businesses -- ones whose intrinsic value will far exceed the carrying value assigned to Berkshire's balance sheet over time. This is one reason Berkshire shares usually command a heavy premium to book value.
There could be something else going on here. The chart clearly shows Berkshire's price-to-book multiple has been on a downward trajectory for years. This might have to do with Buffett's age -- the "Buffett premium" may be dwindling as his mortality comes into focus. But with the price-to-book multiple now approaching one, whatever Buffett premium shares held in the past is effectively gone. The market is pricing Berkshire as an average company when history -- and common sense -- shows it is anything but.
This isn't unusual, but it's a treat when it occurs. As Buffett himself once said, "Market price and intrinsic value often follow very different paths -- sometimes for extended periods -- but eventually they meet."