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[redskin]

It's up to you to pay whatever multiple you want...

 

However my take on this is that intrinsic value is (I think) the present hypothetical liquidation value plus a discounted future stream of earnings.  That seems to be all the money you can ever derive from the business unless I'm forgetting something.

 

So the size of the investment portfolio contributes to the future income stream that you discount, but I don't think you can exaggerate it's value in the hypothetical liquidation component because of the offsetting insurance liabilities.  But that's just my method.

 

Eric and petec, I think we all agree.

 

The present hypothetical liquidation value is $0. Assuming berkshire estimates its liabilities correctly, then cash and FI of $80 - float of $80 = 0.

 

And the discounted future streams of earnings is (normalized spread)*(float) + (value from growth in float).

 

Petec, I think the two column method is a little optimistic, but whatever, let's move on. There are probably more interesting debates to be had and we pretty much agree with the main drivers.

 

I just read the thread and apologize if you are trying to move on to other topics.  thepupil, are you saying the insurance float liability negates the cash and fixed income investments and the insurance business is only worth the value of the equity securities ($126B) plus a small multiple on underwriting?

[thepupil]

Berkshire is an overcapitalized insurance and operating conglomerate.

 

Take all the businesses and stocks and peel those away. They can be valued separately. These may be part of the insurance company (BNSF is owned by one of the insurance co's for example) from a legal perspective, but at a certain degree of overcapitalization, they are not part of the insurance co for valuation purposes*.

 

What you are left with is an insurance operation with no capital ($80B of fixed income and cash offset by $80B of float). The book value of this business is zero. I don't think it is worth zero. I think it is worth what it will earn over time. It will earn the spread on what it earns from its assets and what it earns/loses from its liabilities (underwriting). At the risk of simplifying too much let's just say this is 4%. So $80B * 4% = $3.2B. I would then multiply that by a reasonable multiple.

 

Let's tax affect it to $2.3B and put 10-20X on there = $23 - $46B. So I think that operation with zero book value and zero liquidation value is worth $23-$46B. By no means do I think it is worthless. I just don't think it is worth $80B, which the two column method and its use of "investments per share" implies.

 

I should also note that the more fervent of buffett devotees may object to such slicing and dicing up of Berkshire like this because there are synergies between the financial/insurance side (what i call the no capital insurance co, ie the thing with $0 book and that i think is worth $23-$46B) and the rest of Berkshire. I don't fully disagree. Berkshire is a going concern. But in trying to figure out what i am paying for this business and what it is "worth", I find it useful to slice it up in this manner.

 

What Tilson does is use investment per share AND adds capitalized underwriting profits, which i think is double counting and very aggressive. Hemay or may not think so. Aggressive valuations make for better powerpoints and higher price targets.

 

 

*Imagine an insurance co with 99% equity to assets. You would just look at the equity and value it because it is so overcapitalized that the relationship between assets and liabilities would not matter. You'd just look at the assets.

 

 

[redskin]

Berkshire is an overcapitalized insurance and operating conglomerate.

 

Take all the businesses and stocks and peel those away. They can be valued separately. These may be part of the insurance company (BNSF is owned by one of the insurance co's for example) from a legal perspective, but at a certain degree of overcapitalization, they are not part of the insurance co for valuation purposes*.

 

What you are left with is an insurance operation with no capital ($80B of fixed income and cash offset by $80B of float). The book value of this business is zero. I don't think it is worth zero. I think it is worth what it will earn over time. It will earn the spread on what it earns from its assets and what it earns/loses from its liabilities (underwriting). At the risk of simplifying too much let's just say this is 4%. So $80B * 4% = $3.2B. I would then multiply that by a reasonable multiple.

 

Let's tax affect it to $2.3B and put 10-20X on there = $23 - $46B. So I think that operation with zero book value and zero liquidation value is worth $23-$46B. By no means do I think it is worthless. I just don't think it is worth $80B, which the two column method and its use of "investments per share" implies.

 

I should also note that the more fervent of buffett devotees may object to such slicing and dicing up of Berkshire like this because there are synergies between the financial/insurance side (what i call the no capital insurance co, ie the thing with $0 book and that i think is worth $23-$46B) and the rest of Berkshire. I don't fully disagree. Berkshire is a going concern. But in trying to figure out what i am paying for this business and what it is "worth", I find it useful to slice it up in this manner.

 

What Tilson does is use investment per share AND adds capitalized underwriting profits, which i think is double counting and very aggressive. Hemay or may not think so. Aggressive valuations make for better powerpoints and higher price targets.

 

 

*Imagine an insurance co with 99% equity to assets. You would just look at the equity and value it because it is so overcapitalized that the relationship between assets and liabilities would not matter. You'd just look at the assets.

 

Wouldn't the two column approach be $230b of cash and investments partially funded by the $80b float + a multiple of pre tax operating earnings of approximately $18b.  I'm not sure where you get 80-80=0?

[redskin]

Sorry.  I think I understand what you are saying.  The insurance company is making little spread as long as Berkshire continues to hold the excess cash and short term fixed income.  You are still using the 2 column method but fully deducting the float liability.  Cash and investments (230B)- Float (80B) = 150B + Operating earnings (18B)X multiple (10?)

[thepupil]

here's a slide from a presentation i did on valuing berkshire (I can't share the whole thing); this portion just piggy backed off brooklyn investor.  Notice how bonds & cash corresponds to float.

 

I am trying to value this portion of the business (the combination of the cash + bonds and the float). I don't think it is worth $80B. Two column method makes it worth $80B.

 

The two column method is about how liabilities are accounted for. It accounts for financial debt by deducting interest. It accounts for the deferred tax liability by saying it is worth $0 because it has such low present value and no coupon (I agree with this).

 

It accounts for float by adding it back fully because you have underwriting profits. I don't agree with this for the reasons I've stated.

 

Just peel out the stocks and the operating businesses and think about what you would pay for a company with $80B of cash and fixed income and $80B of insurance float and the underwriting record and float growth track record of berkshire. You may get to $80B but you'd have to be pretty aggressive.

 

 

 

 

 

[rb]

I think that the assumption that BRK hold the float in cash or near cash in incorrect. Yes, BRK tends to have a lot of cash around but why should we assume that all that cash is the float as opposed to the idea that some part of the cash is float and another is holdco cash waiting to be invested?

 

WB said that because of the insurance cos he wants to have at least $20B in cash, let's say that that he would be really comfortable with $30B and call that float cash. In 2014 the insurance cos had $27B of fixed income. That's $57B of cash and fixed income against a float of $84B so about 2/3.

 

I think that making the assumption that all the float is cash or FI significantly understates the value creating characteristics of the insurance cos and thus their overall value.

 

Also why would you count the float liabilities at face value when they are so long dated?

[Hielko]

He's valuing the earnings power of the insurance business, how big/small the assets/liabilities are not relevant for that exercise. I agree with him that just taking the insurance assets at face value and ignoring the liabilities paints an overly optimistic picture. No matter how you slice it, there are tons of regulatory restrictions on the float that makes it worth less than a dollar of cash at the hold co level (and of course, you sometimes need it to actually pay insurance claims).

[thepupil]

maybe it's 2/3 of the float needs to be kept around in low returning assets, maybe it's half, maybe it's 100%.

 

I think we can all agree it's not 0% and Berkshire could not dividend out that $80B ( which is why i dislike "investments per share", which no one would talk about if it wasn't used in his letter 20 years ago and rates were very different) or buy an $80B company for cash.

 

I'm not an insurance regulator and don't know the exact requirements. It just seems that Berkshire likes to keep a hell of a lot of cash and fixed income around despite hating on cash and fixed income all the time.

 

Like I said, if my valuation method understates true intrinsic value, then I'm undersized in the name and underestimating it. I'm fine with that. As a shareholder, I would love to be surprised to the upside and be wrong and see more cash and fixed income converted to higher returning assets. 

 

I'm not counting float at face value (book value does that). I'm using my perceived capital requirements (which as you point out, may be wrong and overly burdensome) to determine the earnings power of the float over time.

 

 

[ERICOPOLY]

No matter the industry, I don't see how intrinsic value could ever exceed the discounted value of all future distributable earnings in addition to the present liquidation value. 

 

You can only squeeze so much juice from a lemon.

 

[cobafdek]

here's a slide from a presentation i did on valuing berkshire (I can't share the whole thing); this portion just piggy backed off brooklyn investor.  Notice how bonds & cash corresponds to float.

 

I am trying to value this portion of the business (the combination of the cash + bonds and the float). I don't think it is worth $80B. Two column method makes it worth $80B.

 

The two column method is about how liabilities are accounted for. It accounts for financial debt by deducting interest. It accounts for the deferred tax liability by saying it is worth $0 because it has such low present value and no coupon (I agree with this).

 

So maybe Buffett's loose and ambiguous way of talking about float is the reason for the confusion and past-talking-among-ourselves in this thread.

 

It accounts for float by adding it back fully because you have underwriting profits. I don't agree with this for the reasons I've stated.

 

Just peel out the stocks and the operating businesses and think about what you would pay for a company with $80B of cash and fixed income and $80B of insurance float and the underwriting record and float growth track record of berkshire. You may get to $80B but you'd have to be pretty aggressive.

 

I think you are correct if BRK's float = cash + short-term fixed-income, some discount should be applied.

 

However, Buffett in his discussion of the two-column method of valuing BRK seems to use the term "float" loosely.  In one place, he uses what seems to be the strict definition of float as premiums we have received but don't own yet (reserves and unearned premiums).  Indeed, in the balance sheet, loss reserves + unearned premiums = cash + short-term fixed-income.  Then he goes on and talks about Investments, defined as = float + retained earnings.  I take retained earnings as earned premiums, which formerly was a part of float.

 

Notice that the line item Equity (within Investments) in the balance sheet is sizable, and separate from Cash + Short-term fixed.  Some may have the impression that float includes Equity, but strictly speaking it should be termed "formerly float."  Definitions are key.

 

So maybe Buffett's loose and ambiguous way of discussing float and "float" is responsible for the confusion and talking-past-one-another in this thread.

 

 

[redskin]

maybe it's 2/3 of the float needs to be kept around in low returning assets, maybe it's half, maybe it's 100%.

 

I think we can all agree it's not 0% and Berkshire could not dividend out that $80B ( which is why i dislike "investments per share", which no one would talk about if it wasn't used in his letter 20 years ago and rates were very different) or buy an $80B company for cash.

 

I'm not an insurance regulator and don't know the exact requirements. It just seems that Berkshire likes to keep a hell of a lot of cash and fixed income around despite hating on cash and fixed income all the time.

 

Like I said, if my valuation method understates true intrinsic value, then I'm undersized in the name and underestimating it. I'm fine with that. As a shareholder, I would love to be surprised to the upside and be wrong and see more cash and fixed income converted to higher returning assets. 

 

I'm not counting float at face value (book value does that). I'm using my perceived capital requirements (which as you point out, may be wrong and overly burdensome) to determine the earnings power of the float over time.

The two column analysis is included in every annual report by Buffett.  It was not just mentioned 20 years ago when the yield curve was different.  I would assume the Berkshire insurance subsidiaries price their insurance contracts differently with short term interest rates under 1% versus 4-5% in the past.  Following is Buffett's discussion of float in last years letter.  He says the float liability is 'dramatically less than the accounting liability'.  How much is dramatically less? 

 

"So how does our float affect intrinsic value? When Berkshire’s book value is calculated, the full amount

of our float is deducted as a liability, just as if we had to pay it out tomorrow and could not replenish it. But to think

of float as strictly a liability is incorrect; it should instead be viewed as a revolving fund. Daily, we pay old claims

and related expenses – a huge $22.7 billion to more than six million claimants in 2014 – and that reduces float. Just

as surely, we each day write new business and thereby generate new claims that add to float.

If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this

liability is dramatically less than the accounting liability. Owing $1 that in effect will never leave the premises –

because new business is almost certain to deliver a substitute – is worlds different from owing $1 that will go out the

door tomorrow and not be replaced. The two types of liabilities are treated as equals, however, under GAAP."

[rb]

The two column analysis is included in every annual report by Buffett.  It was not just mentioned 20 years ago when the yield curve was different.  I would assume the Berkshire insurance subsidiaries price their insurance contracts differently with short term interest rates under 1% versus 4-5% in the past.  Following is Buffett's discussion of float in last years letter.  He says the float liability is 'dramatically less than the accounting liability'.  How much is dramatically less? 

 

"So how does our float affect intrinsic value? When Berkshire’s book value is calculated, the full amount

of our float is deducted as a liability, just as if we had to pay it out tomorrow and could not replenish it. But to think

of float as strictly a liability is incorrect; it should instead be viewed as a revolving fund. Daily, we pay old claims

and related expenses – a huge $22.7 billion to more than six million claimants in 2014 – and that reduces float. Just

as surely, we each day write new business and thereby generate new claims that add to float.

If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this

liability is dramatically less than the accounting liability. Owing $1 that in effect will never leave the premises –

because new business is almost certain to deliver a substitute – is worlds different from owing $1 that will go out the

door tomorrow and not be replaced. The two types of liabilities are treated as equals, however, under GAAP."

The way I see it is that the float liability is worth about 60% of the face value.

[thepupil]

http://finance.yahoo.com/news/warren-buffett-plans-invest-32-163654606.html

 

RB, in support of your argument, Warren continues to reiterate the $20B cash as his minimum (which if you count all fixed income as working capital  for insurance) means Berkshire needs to keep ~$50B in cash and fixed income around, leaving him $10B more after PCP deal to buy stuff.

 

One way to reconcile the $20B minimum with the much larger level of hoarding (the hoarding as the slide i posted shows float = cash & FI), is that it doesn't make sense for Berkshire to deploy small bits of capital into new businesses (ie a $2B acquisition does nothing). So there is a lag between when cash gets invested and as it builds (what a boglehead would call "cash drag"). While this is a negative over time, it's not nearly as bad as having to keep the full value in cash.

 

So i revise my position on the float requirements in favor of the more bullish to $50B rather than $80B.

 

Longinvestor, rb, others. Enjoy this moment.

 

I bought more Berkshire today. All that arguing made me realize that even though I'm less excited than others, I still believe berkshire is very undervalued and it is just as undervalued as lots of other things i own.

 

I think that the assumption that BRK hold the float in cash or near cash in incorrect. Yes, BRK tends to have a lot of cash around but why should we assume that all that cash is the float as opposed to the idea that some part of the cash is float and another is holdco cash waiting to be invested?

 

WB said that because of the insurance cos he wants to have at least $20B in cash, let's say that that he would be really comfortable with $30B and call that float cash. In 2014 the insurance cos had $27B of fixed income. That's $57B of cash and fixed income against a float of $84B so about 2/3.

 

I think that making the assumption that all the float is cash or FI significantly understates the value creating characteristics of the insurance cos and thus their overall value.

 

Also why would you count the float liabilities at face value when they are so long dated?

[scorpioncapital]

I'm trying to understand something.

 

PCP had 1.7 billion or so of free cash flow after capex.

Phillips 66 has double or about 3.6 billion of free cash flow after sustaining capex.

 

The purchase price for both companies is roughly the same. Say 38 billion vs around 41 billion.

 

How can Berkshire justify paying the same amount of cash for two companies one of which has double the free cash flow as the other?

 

Perhaps there's a lesson here but I can't see it exactly yet!

 

[rb]

It's because PCP has much better growth prospects than Phillips 66.

[100 Shares]

PSX is 43B before a premium is applied. PCP was around 26B before the premium. And equity is now at 32 not 38

[Guest longinvestor]

It's because PCP has much better growth prospects than Phillips 66.

 

Are they also going to absorb/tuck-in a lot of capital?

[rb]

It's because PCP has much better growth prospects than Phillips 66.

 

Are they also going to absorb/tuck-in a lot of capital?

I think so but I didn't want to bring it up because that's more my view than a generally accepted one.

[scorpioncapital]

It'll be interesting to see who wins the race: the tortoise or the hare :)

I think PSX in their presentation has stated they have some goals to increase profits in the next few years too. I was just struck how similar the valuations are yet the FCF is not the same at all.

[100 Shares]

It'll be interesting to see who wins the race: the tortoise or the hare :)

I think PSX in their presentation has stated they have some goals to increase profits in the next few years too. I was just struck how similar the valuations are yet the FCF is not the same at all.

 

The valuations aren't similiar! I just looked it up in more detail than my previous post because I was curious. Berkshire announced PCP acquisition on Mon Aug 10. The corresponding equity market values on Friday Aug 7 were 26.6B for PCP and 42.2B for PSX. This is nearly 60% more. Everyone's comments about PCP having better growth prospect and areas to deploy capital are likely true but the bottom line is that these aren't similiar size acquisitions that could have been interchangeable. Using your FCF numbers of 1.7 and 3.6 make te multiples for these businesses 15.6 and 11.7, so hardly double the free cash flow for the same price.

[scorpioncapital]

I thought the deal was for $32 billion plus/minus(?) the already 3% stake. The extra $9-10 billion represents a FCF of $2 billion. If I can buy a business that earns $2 billion free cash flow for $10 billion that seems extremely cheap. But as you mentioned, the growth would factor into that.

[rb]

I thought the deal was for $32 billion plus/minus(?) the already 3% stake. The extra $9-10 billion represents a FCF of $2 billion. If I can buy a business that earns $2 billion free cash flow for $10 billion that seems extremely cheap. But as you mentioned, the growth would factor into that.

Also the 32B for PCP includes the control premium. You'd figure that if they were to swallow Phillips 66 it wouldn't be at the market price. They'd have to pay a hefty premium for that.