I'm a big fan of Warren Buffett and a longtime investor in Berkshire Hathaway (NYSE: BRKa) (NYSE: BRKb). But over the past two years, my investment in Berkshire stock has not moved much. Rather than being the cause of frustration or angst, the stagnant stock price has created a welcome opportunity for me to increase my holdings in Berkshire at an attractive price.
Like other stocks, Berkshire tends to fall in and out of favor with the market, and it currently seems to be out of favor. On the one hand, cautious short-term investors have shied away from the insurance industry, as issues with companies like Marsh & McLennan (NYSE: MMC) and AIG (NYSE: AIG) have surfaced, combined with mounting losses caused by Hurricanes Wilma and Katrina. On the other hand, momentum investors are busy pushing valuations of Google (Nasdaq: GOOG) into the stratosphere.
But in the long term, popularity doesn't matter -- cash flow does. And Berkshire's underlying businesses are slowly, steadily increasing their value.
Berkshire
's book value in its historical context
Berkshire reports its book value quarterly, and on the inside cover of the annual report, the company shows growth in book value annually back to 1965. Since 1965, the average annual growth rate of Berkshire's book value has been 22%. Since 1990, it has been a slightly more modest 19%.
Today, the book value per share of Class A stock is $57,010. On Oct. 26, the shares were trading at $85,200, or approximately 1.5 times their book value. Since 1990, Berkshire Hathaway stock has traded between about 1.35 to 2.44 times book value. At the current multiple, the shares are trading at the lower end of their historical range.
In early 1995, when the shares traded at a rich 2.44 times book value, Buffett commented in that year's letter to shareholders: "Historically, Berkshire shares have sold modestly below intrinsic value. But recently, the discount has disappeared, and occasionally a modest premium has prevailed."
On the other hand, in early 2000, at the height of the dot-com boom, when many thought that Buffett was out of touch with the markets, Berkshire stock traded at 1.35 times book value. Buffett's comment that year was: "Charlie and I can assure you that intrinsic value far exceeds our $57.8 billion book value. Businesses such as See's and Buffalo News are now worth fifteen to twenty times the value at which they are carried on our books. Our goal is to continually widen this gap at all subsidiaries."
In hindsight, the stock was a real bargain in 2000, as 1.35 times book value translated into a price of around $50,000 for a Class A share, and the returns on an investment in Berkshire that year easily outpaced the broader market in subsequent years. Although not quite as attractive today at it was in 2000, at 1.5 times book value, the stock is more attractively priced today than it has been for the better part of the past 15 years.
An intrinsic value approach to valuation
Here is a great tool for estimating Berkshire's intrinsic value by using a number of different assumptions and scenarios. The online calculator also allows for historical analysis. Using the conservative scenario, the calculator yields a current intrinsic value per Class A share of $101,861, also indicating that the stock is significantly undervalued.
Curious to see whether this intrinsic value approach would lead to similar conclusions as the book value approach about whether the stock was undervalued at different points in time, I went back to 1990 and compared the two. Interestingly, I found that the two approaches indeed led to similar conclusions about valuation: When the online calculator indicated that price was low relative to intrinsic value, the price-to-book ratio was also low (specifically, at the height of the dot-com boom in 2000 and in the early 1990s). In the mid-1990s, according to the intrinsic value calculator, price rose above intrinsic value (as noted by Buffett in his 1995 letter) at around the same time that the price-to-book ratio peaked.
A conservative estimate of future returns
Although both an intrinsic value analysis and an analysis of historical book value clearly indicate to me that the stock is now undervalued, as I did my research, I also wanted to estimate potential future returns on an investment in Berkshire stock today. To do that, I used some conservative assumptions about the stock over the next 10 years.
Rather than the historical increases in book value of 22% or 19%, I assumed that Berkshire's book value only grows by 15% per year for the next 10 years. At that rate, the book value per share would go from $57,010 today to $230,637 by 2015. I then assumed that in 2015, the stock would be trading at a historical low in terms of multiple of book value (1.35 times). That would mean that the shares would be priced at $311,360. On the basis of those assumptions, if I buy the shares today at $85,200, I would earn a 265% return on my initial investment or a compound annual rate of return of 13.8%. On a risk-adjusted basis, I have a hard time coming up with anything that comes close.
On the basis of the logic above, I recently added a significant amount to my existing position in Berkshire Hathaway. Other value investors may want to consider doing the same.
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Fool contributor Salim Haji lives in Denver and owns shares of Berkshire Hathaway. He does not own shares in any other of the companies mentioned. The Motley Fool is investors writing for investors.
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