Berkshire Is at least 20% Undervalued

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.

Insurance
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.

Regulated businesses
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).

Investments
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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Brendan Mathews owns share of Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway, Coca-Cola, and Wells Fargo. The Fool owns shares of and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Wells Fargo, Berkshire Hathaway, and Coca-Cola. Motley Fool newsletter services have recommended creating a write covered strangle position in American Express. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 05, 2012, at 3:51 PM, clydefrog2 wrote:

    You forgot to subtract out the $71 billion of float from the the $100 billion investment portfolio. The float does not belong to shareholders, as it is only an interest-free "loan," and therefore should not be included when calculating the market cap.

  • Report this Comment On April 05, 2012, at 4:59 PM, daltonjohn wrote:

    I would be very interested to hear if anybody agrees with the comment by clydefrog2 -- it sounds sensible but I'm aware that various people such as Whitney Tilson normally include the float. I would be intrigued to know why.

  • Report this Comment On April 05, 2012, at 5:11 PM, portefeuille wrote:
  • Report this Comment On April 05, 2012, at 7:52 PM, TMFWillSommers wrote:

    Hi Clydefrog2:

    Thanks for reading my article. The question of including float in the valuation isn't that clear-cut. It's actually a topic of much discussion.

    Here's my logic for including it. Assuming Berkshire's insurance business continues (and grows), the float will never be paid back. And, Berkshire is entitled to all the earnings generated by the float. For those reasons, I decided to include the full value of investments, a portion of which is funded by float.

    The Fool's BRK discussion board is a good place to discuss these types of topics.

    Regards,

    Brendan

  • Report this Comment On April 05, 2012, at 9:34 PM, jerryguru69 wrote:

    The problem with your analysis, that is the under-valuation is important only if investors realize it at some point and drive up the share price.

    I see no evidence that is will happen anytime soon: I have been patiently waiting a few years for this, but no luck so far.

  • Report this Comment On April 09, 2012, at 4:23 PM, DargFool wrote:

    Since Warren doesn't like to purchase companies without a 30% discount to intrinsic value, then Berkshire is not a buy according to Warren.

    So if you have money and like Berkshire, write cash covered puts on the Brk b shares. The premium isn't all that great, but careful selection can yield 8-10% a year with a little bit of downside protection.

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