Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) is notoriously difficult to value. Fortunately, Warren Buffett provides guidance in his annual letter. I have simply followed his framework, applied some fifth-grade math, and made conservative assumptions. My finding is that Berkshire is at least 20% undervalued.
This is probably the trickiest business to value. At Berkshire, insurance generates positive economics in two ways: underwriting profits and float. Underwriting profits are the difference between the premiums collected and claims paid.
Berkshire is somewhat unique among insurers because it regularly generates an underwriting profit. Berkshire has generated an underwriting profit for nine consecutive years -- a total of $17 billion. Float is the money that Berkshire holds after collecting premiums while waiting to pay claims. At Berkshire, float is quite sizable ($71 billion) and quite valuable, as it amounts to an interest-free loan. To value this business, I focus on the underwriting profits. The value of the float is captured in the investment portion of my valuation. Underwriting profits were only $248 million in 2011, which is significantly lower than the $2 billion in underwriting profits in 2010. This is because insurance is a highly cyclical market. For valuation purposes, I use the average of the past nine years ($1.9 billion) and apply a reasonable multiple (10 times). That puts the value of insurance, not including float, at $19 billion.
Berkshire's two big regulated businesses are electric utilities (MidAmerican) and railroads (Burlington Northern). MidAmerican earned $1.2 billion in 2011, and Burlington Northern earned $3 billion. According to Morningstar, stocks in the utilities and railroad industry both trade at an average of 16 times earnings. Applying the same multiple implies a total value of $67 billion.
Manufacturing, service, and retail
Berkshire has a large portfolio of wholly owned businesses that range from "lollipops to jet airplanes." These businesses were hand-selected by Buffett, and it's fair to assume they are solid bets in terms of growth, stability and profitability. Let's value them at 16 times earnings, which is the average P/E of the S&P 500. Since these businesses earned $3 billion in 2011, that implies a value of $49 billion. Additionally, this doesn't include Lubrizol, which Buffett purchased in March 2011. Buffett paid $9 billion in cash and assumed $700 million in debt to purchase Lubrizol. It's probably worth more than that, but to be conservative, I'm valuing Lubrizol at its total purchase price of $9.7 billion. That puts the total value of these businesses at $58 billion.
Finance and financial products
Berkshire owns a manufactured housing business (Clayton Homes) and two leasing business (CORT and XTRA), and Buffett also makes fixed-income and derivative deals under the name BH Finance. To value this business unit, I apply a reasonable pre-tax earnings multiple (eight times) to the earnings from the housing and leasing businesses. Those businesses generated $309 million in pre-tax earnings in 2011, which equates to a value of $2.5 billion. I have not included the earnings from BH Finance per Buffett's guidance. On page 44 of the latest 10-K, he says, "We believe the amount of investment gains/losses included in earnings in any given period typically has little analytical or predictive value." However, I do capture the value of these investment earnings in my "investments" valuation (next section).
In addition to its wholly owned businesses, Berkshire holds stock, cash, fixed income, and loans. The market value of the equities portfolio, which includes some of the very largest stakes in American Express (NYSE: AXP ) , Coca-Cola (NYSE: KO ) , IBM (NYSE: IBM ) , and Wells Fargo (NYSE: WFC ) , is $77 billion. Cash is $37 billion, fixed income is $32 billion, and loans are $14 billion. If you net out notes payable and other borrowings, the total value of the investment portfolio is $100 billion. This reflects the value of Berkshire's float, which Berkshire doesn't technically own, but has free use of, assuming the insurance business continues to grow. I have not deducted deferred taxes from the value of the investments. Berkshire has generated significant capital gains over the years that haven't been realized. If Berkshire were to liquidate its investments, it would have a significant tax bill -- $38 billion. However, it is unlikely that Buffett will ever sell core investments like Coca-Cola or American Express, which implies that the tax bill will probably never be paid.
Foolish bottom line
Summing the value of these four segments yields a value of $244 billion. Berkshire's market cap is $201 billion. Thus, Berkshire's value, using conservative assumptions, is some 20% higher than the current trading level.
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