1.2x P/BV entry point

[Gray Fox]

+1 on the look - through method.

 

Looking to next year, if you add

 

$1.0B in KHC earnings ( 325MM shares X $3.22 EPS)

$1.5B PCP earnings

$18B Operating earnings from BRK ( up from ~$16-17B this year)

6B  Undistributed earnings from a/o stocks

 

26.5B in earnings next year assuming no recession and normal Insurance results.

 

Today's market cap is 325B

 

So 12.2 X earnings.

 

This may be a little optimistic but it's reasonable.

 

Ummm what about the taxes on those operating earnings? That takes the 26.5bn down to 20.5bn.  I think BRK is cheapish at these levels but 15.8x is different than 12.2x

[scorpioncapital]

I found this article quite nice and straightforward: http://www.kapitalust.com/the-intrinsic-value-of-berkshire-hathaway/

 

He uses a present value calculator and asks: What price should I buy to get 10% return per year? The article was written when BV was $97 per B share. It assumes a "sell-ratio" of 1.5x BV. The conclusion is you should buy at up to $146/share. However, it'd be nice to see this calculation assuming a lower check-out ratio, let's say the present one. Also to assume you might want a higher return like 15%.

 

I would imagine it's not rocket science to eyeball this. If Berkshire can grow at 15% per year BV and the ratio is a "measly" 1.2x, then certainly we are approaching these kind of numbers within say another $10/share drop.

 

PS. So I tried to calculate assuming 1.2 P/BV exit in 10 years assuming 10% BV growth and current price of $128/ B share. Assuming 1.65 billion shares outstanding, the current return seems to be 13.9%? E.g. 246b * 1.1^10 = 638 billion * 1.2 = 765 billion or ~ $464/share. From $128 to $464 in 10 years is roughly 13.9 or so% per year. Does this seem right? It's not too bad. Buffett would be 95 years old, Munger would be in the 100s. All this assumes that capital can be reinvested at 10% when dealing with something on the order of half a trillion dollars!

 

 

 

[Shane]

Did some quick work tonight, mostly from 2014 AR.  All after tax and interest.

 

Operating businesses (Including PCP) = 13,758

Look-through equity portfolio (proportionate, including KHC) = 9409

 

Totals $23.167B.  7.3% earnings yield.  13.68x P/E.

 

Am I missing something here?  Should I be backing out any corporate expenses?  I essentially assume the insurance always operates at a 100 combined ratio.

 

A lot of the big equity positions are not expected to grow earnings... however, the operating businesses will probably grow decently within the next 5 years.

[no_free_lunch]

Thanks Shane!

 

Did you factor in the cost to do the PCP deal?  I don't know the terms if they are issuing stock or paying cash but there is a small amount of dilution in either case.

[Shane]

Thanks Shane!

 

Did you factor in the cost to do the PCP deal?  I don't know the terms if they are issuing stock or paying cash but there is a small amount of dilution in either case.

 

It is all cash, so I don't see why there would be dilution.  It is basically cash converted to an operating business.

 

I am actually starting to think Berkshire will grow the cash flow stream more quickly now.  Consider this, (Net Income of $23.167B)/(Equity of $249B) = 9.3% ROE for last year.  I am using the most recent equity figure and an adjusted TTM earnings figure so let's say normalized 10%.  They retain all cash (Either via dividend from equity positions that aren't invested by the business) or as operating cash flow from subsidiaries.  This means the company should grow at 10% going forward. 

 

I must admit I am a bit surprised this is only yielding an ROE of 10%... I think it must be because the float is held at fair value and high P/E's penalize this figure?  It might be worth adjusted equity for the cost basis of the float.

 

If you look back historically, the cash flow growth has been closer to 10%+ than the 5-7% figure.  Original Mungerville - can you confirm this with your prior look-through analysis?

 

Thoughts?  What is confusing me is this is looking cheaper and cheaper to me at today's price... However we are still above Warren's 1.2x BV level where only last year he said he used that level because it would be buying shares from shareholders for "90 cents on the dollar"... this is looking like much less than 90 cents on the dollar.  Worried I am missing some costs, this is an unusual way to value a company.

[thepupil]

I think the cash flow stream can reasonably be expected to grow 5-7% for a total return of maybe 13-15% at today's price.  I include acquisitions in my expectation for 5-7% as I basically consider acquired earnings normal growth as if a business had reinvested in itself (ie added another manufacturing facility).

 

Is this the right way to think about it?

 

All earnings at Berkshire are used to keep growing earnings (they are retained, not dividended or share repurchased out) so won't total return be equal to (earnings growth + return from change in multiples) instead of (earnings yield + earnings growth + return from change in multiples).

 

The cash flow stream would not grow without capex, particularly the utility and railroad and the industrials. I think the only types of businesses where you can say total return = earnings yield + growth in earnings are See's Candy types of things where almost no capex is needed for growth. If berkshire triples earnings over the next 10 yrs and the multiple doesn't change, shouldn't the stock price triple. But it should not triple + give you even more for earnings over that time period.

 

You can do this type of calculation with dividend yield or truly free cash flow yield (after growth capex), but earnings yield seems too generous right?

 

For example, the S&P 500 trades at 18X (5.5% earnings yield) and a 1.9% dividend yield.

 

If earnings per share grow by 6% per year for the next ten years and there is no multiple change, what is the total return? By the earnings yield + growth formula you use for berkshire it would be 11.5% (a cumulative 196% return over 10 yrs). But that's not what it would be, instead it would be dividend yield + earnings growth, right? Because the non dividended earnings are what is used to grow the EPS (either through investment or share repurchase).

 

Growth isn't free.

 

 

[Shane]

I think the cash flow stream can reasonably be expected to grow 5-7% for a total return of maybe 13-15% at today's price.  I include acquisitions in my expectation for 5-7% as I basically consider acquired earnings normal growth as if a business had reinvested in itself (ie added another manufacturing facility).

 

Is this the right way to think about it?

 

All earnings at Berkshire are used to keep growing earnings (they are retained, not dividended or share repurchased out) so won't total return be equal to (earnings growth + return from change in multiples) instead of (earnings yield + earnings growth + return from change in multiples).

 

The cash flow stream would not grow without capex, particularly the utility and railroad and the industrials. I think the only types of businesses where you can say total return = earnings yield + growth in earnings are See's Candy types of things where almost no capex is needed for growth. If berkshire triples earnings over the next 10 yrs and the multiple doesn't change, shouldn't the stock price triple. But it should not triple + give you even more for earnings over that time period.

 

You can do this type of calculation with dividend yield or truly free cash flow yield (after growth capex), but earnings yield seems too generous right?

 

For example, the S&P 500 trades at 18X (5.5% earnings yield) and a 1.9% dividend yield.

 

If earnings per share grow by 6% per year for the next ten years and there is no multiple change, what is the total return? By the earnings yield + growth formula you use for berkshire it would be 11.5% (a cumulative 196% return over 10 yrs). But that's not what it would be, instead it would be dividend yield + earnings growth, right? Because the non dividended earnings are what is used to grow the EPS (either through investment or share repurchase).

 

Growth isn't free.

 

Hi thepupil.  My understanding of what you are saying is that because the company would have to invest cash to grow, it is incorrect to use Earnings yield + growth to approximate total return?

 

I have to be honest that I am having a hard time at the moment trying to disprove your point here.  I have seen the earnings yield + growth method used by other investors and maybe have not given it enough thought.  Thanks for bringing this up.  Am at work now without much time, will need to have a bit of a think.

[original mungerville]

Did some quick work tonight, mostly from 2014 AR.  All after tax and interest.

 

Operating businesses (Including PCP) = 13,758

Look-through equity portfolio (proportionate, including KHC) = 9409

 

Totals $23.167B.  7.3% earnings yield.  13.68x P/E.

 

Am I missing something here?  Should I be backing out any corporate expenses?  I essentially assume the insurance always operates at a 100 combined ratio.

 

A lot of the big equity positions are not expected to grow earnings... however, the operating businesses will probably grow decently within the next 5 years.  I think the cash flow stream can reasonably be expected to grow 5-7% for a total return of maybe 12-14% at today's price.  I include acquisitions in my expectation for 5-7% as I basically consider acquired earnings normal growth as if a business had reinvested in itself (ie added another manufacturing facility).

 

Shane, this all sounds reasonable - what I would have expected at this price for BRK (ie 13-14x p/e, 7% yield) however, why are you adding your 5-7% growth to your 7% earnings yield to get to 12-14% total return. There is something very wrong with this. If the 13-14x multiple holds going forward, then you get that 5-7% growth and that is all. How to you figure you can get 12-14% return unless you assume multiple expansion?

[no_free_lunch]

I agree with pupil on the return.  Your long-term return is dividend + share buybacks + growth in earnings.  Other than multiple expansion I can't see how else you get a return.  With BRK it's basically the growth.

[Shane]

Yes I think we can all agree my thinking on the total return was flawed.  I'll go back and edit the post to make things cleaner (and remove an embarrassing error ha).

[redskin]

I think the cash flow stream can reasonably be expected to grow 5-7% for a total return of maybe 13-15% at today's price.  I include acquisitions in my expectation for 5-7% as I basically consider acquired earnings normal growth as if a business had reinvested in itself (ie added another manufacturing facility).

 

Is this the right way to think about it?

 

All earnings at Berkshire are used to keep growing earnings (they are retained, not dividended or share repurchased out) so won't total return be equal to (earnings growth + return from change in multiples) instead of (earnings yield + earnings growth + return from change in multiples).

 

The cash flow stream would not grow without capex, particularly the utility and railroad and the industrials. I think the only types of businesses where you can say total return = earnings yield + growth in earnings are See's Candy types of things where almost no capex is needed for growth. If berkshire triples earnings over the next 10 yrs and the multiple doesn't change, shouldn't the stock price triple. But it should not triple + give you even more for earnings over that time period.

 

You can do this type of calculation with dividend yield or truly free cash flow yield (after growth capex), but earnings yield seems too generous right?

 

For example, the S&P 500 trades at 18X (5.5% earnings yield) and a 1.9% dividend yield.

 

If earnings per share grow by 6% per year for the next ten years and there is no multiple change, what is the total return? By the earnings yield + growth formula you use for berkshire it would be 11.5% (a cumulative 196% return over 10 yrs). But that's not what it would be, instead it would be dividend yield + earnings growth, right? Because the non dividended earnings are what is used to grow the EPS (either through investment or share repurchase).

 

Growth isn't free.

 

I would consider the depreciation charges as the amount of capital needed to maintain the position of the existing businesses to grow with the overall economy.

 

Berkshire's purchases of property and equipment in 2014 was approximately $15b, more than double the 7.3B depreciation and amortization charge.  A lot of the additional capex was used in the utility and railroad.  Buffett has talked in the past how he believes they will earn adequate returns on these investments (10-12% pre tax?).  So the additional $8b capex in these regulated businesses should add $800-950mm. 

 

In addition, the excess cash flows are used to purchase additional streams of income like VanTuyl.  With these additional investments, pre tax operating earnings have increased by 14% in the first half of 2015 compared to 2014.  It should be even higher over the entire year as more of the utility projects are coming online and the Duracell and KHC deals close in the 2nd half.

 

The PCP deal alone will increase pre tax operating earnings by approximately 13% and that cash will be replenished quickly to set up the next elephant.  I wouldn't bet against Buffett/Berkshire being able to increase earnings significantly over the next 5-10 years.

 

[original mungerville]

Yes I think we can all agree my thinking on the total return was flawed.  I'll go back and edit the post to make things cleaner (and remove an embarrassing error ha).

 

Don't kick yourself too hard, because you will get more than 5-7% return even if the multiple holds - so good to try and factor in the following:

 

- BRK is providing no dividend right now, but it is safe to say the Buffett's minimal return on capital deployed is probably 10%.

- This means all retained earnings will eventually get deployed at 10% return minimum.

- You have retained earnings growing 5 -7 % which means that that amount that will be deployed at 10% is also growing.

 

The key with valuing BRK correctly, is to factor in that 10% return on new capital employed into your valuation.

 

The earnings yield is 7% right now - so you that is your base yield at these prices. To that you add new capital invested at 10%. So that means your answer has to be between 7-10% return. Now, having said that, if BRK also grows float, by say 2% a year and insurance is half the business, you might get an extra 1% with that. So we might say new capital may actually be invested at 11% - ie 10% + 1% from insurance float.

 

Basically if all new earnings were immediately invested in 10+1% opportunities, and the current multiple held, your return would be 11%. If none of those future earnings get invested ever, and because cash earns 0%, your return would be your 7% (or inverse of the p/e).

 

So your return is probably closer to 11% if you think Buffett will be able to continually deploy capital and 7% if he just sits on cash and doesn't ever pay a dividend.

 

Anyway, factoring the above in to your analysis will improve it.

[thepupil]

I think the cash flow stream can reasonably be expected to grow 5-7% for a total return of maybe 13-15% at today's price.  I include acquisitions in my expectation for 5-7% as I basically consider acquired earnings normal growth as if a business had reinvested in itself (ie added another manufacturing facility).

 

Is this the right way to think about it?

 

All earnings at Berkshire are used to keep growing earnings (they are retained, not dividended or share repurchased out) so won't total return be equal to (earnings growth + return from change in multiples) instead of (earnings yield + earnings growth + return from change in multiples).

 

The cash flow stream would not grow without capex, particularly the utility and railroad and the industrials. I think the only types of businesses where you can say total return = earnings yield + growth in earnings are See's Candy types of things where almost no capex is needed for growth. If berkshire triples earnings over the next 10 yrs and the multiple doesn't change, shouldn't the stock price triple. But it should not triple + give you even more for earnings over that time period.

 

You can do this type of calculation with dividend yield or truly free cash flow yield (after growth capex), but earnings yield seems too generous right?

 

For example, the S&P 500 trades at 18X (5.5% earnings yield) and a 1.9% dividend yield.

 

If earnings per share grow by 6% per year for the next ten years and there is no multiple change, what is the total return? By the earnings yield + growth formula you use for berkshire it would be 11.5% (a cumulative 196% return over 10 yrs). But that's not what it would be, instead it would be dividend yield + earnings growth, right? Because the non dividended earnings are what is used to grow the EPS (either through investment or share repurchase).

 

Growth isn't free.

 

I would consider the depreciation charges as the amount of capital needed to maintain the position of the existing businesses to grow with the overall economy.

 

Berkshire's purchases of property and equipment in 2014 was approximately $15b, more than double the 7.3B depreciation and amortization charge.  A lot of the additional capex was used in the utility and railroad.  Buffett has talked in the past how he believes they will earn adequate returns on these investments (10-12% pre tax?).  So the additional $8b capex in these regulated businesses should add $800-950mm. 

 

In addition, the excess cash flows are used to purchase additional streams of income like VanTuyl.  With these additional investments, pre tax operating earnings have increased by 14% in the first half of 2015 compared to 2014.  It should be even higher over the entire year as more of the utility projects are coming online and the Duracell and KHC deals close in the 2nd half.

 

The PCP deal alone will increase pre tax operating earnings by approximately 13% and that cash will be replenished quickly to set up the next elephant.  I wouldn't bet against Buffett/Berkshire being able to increase earnings significantly over the next 5-10 years.

 

I own the stock and it is my family's largest position. I'm not betting against it, was just questioning the (earnings yield + growth= total return equation). I think berkshire will grow earnings nicely and enjoy a decent return on the capital it deploys.

[Libs]

+1 on the look - through method.

 

Looking to next year, if you add

 

$1.0B in KHC earnings ( 325MM shares X $3.22 EPS)

$1.5B PCP earnings

$18B Operating earnings from BRK ( up from ~$16-17B this year)

6B  Undistributed earnings from a/o stocks

 

26.5B in earnings next year assuming no recession and normal Insurance results.

 

Today's market cap is 325B

 

So 12.2 X earnings.

 

This may be a little optimistic but it's reasonable.

 

Ummm what about the taxes on those operating earnings? That takes the 26.5bn down to 20.5bn.  I think BRK is cheapish at these levels but 15.8x is different than 12.2x

 

Everything in my post was after - tax.

[Guest longinvestor]

I think the cash flow stream can reasonably be expected to grow 5-7% for a total return of maybe 13-15% at today's price.  I include acquisitions in my expectation for 5-7% as I basically consider acquired earnings normal growth as if a business had reinvested in itself (ie added another manufacturing facility).

 

Is this the right way to think about it?

 

All earnings at Berkshire are used to keep growing earnings (they are retained, not dividended or share repurchased out) so won't total return be equal to (earnings growth + return from change in multiples) instead of (earnings yield + earnings growth + return from change in multiples).

 

The cash flow stream would not grow without capex, particularly the utility and railroad and the industrials. I think the only types of businesses where you can say total return = earnings yield + growth in earnings are See's Candy types of things where almost no capex is needed for growth. If berkshire triples earnings over the next 10 yrs and the multiple doesn't change, shouldn't the stock price triple. But it should not triple + give you even more for earnings over that time period.

 

You can do this type of calculation with dividend yield or truly free cash flow yield (after growth capex), but earnings yield seems too generous right?

 

For example, the S&P 500 trades at 18X (5.5% earnings yield) and a 1.9% dividend yield.

 

If earnings per share grow by 6% per year for the next ten years and there is no multiple change, what is the total return? By the earnings yield + growth formula you use for berkshire it would be 11.5% (a cumulative 196% return over 10 yrs). But that's not what it would be, instead it would be dividend yield + earnings growth, right? Because the non dividended earnings are what is used to grow the EPS (either through investment or share repurchase).

 

Growth isn't free.

 

I would consider the depreciation charges as the amount of capital needed to maintain the position of the existing businesses to grow with the overall economy.

 

Berkshire's purchases of property and equipment in 2014 was approximately $15b, more than double the 7.3B depreciation and amortization charge.  A lot of the additional capex was used in the utility and railroad.  Buffett has talked in the past how he believes they will earn adequate returns on these investments (10-12% pre tax?).  So the additional $8b capex in these regulated businesses should add $800-950mm. 

 

In addition, the excess cash flows are used to purchase additional streams of income like VanTuyl.  With these additional investments, pre tax operating earnings have increased by 14% in the first half of 2015 compared to 2014.  It should be even higher over the entire year as more of the utility projects are coming online and the Duracell and KHC deals close in the 2nd half.

 

The PCP deal alone will increase pre tax operating earnings by approximately 13% and that cash will be replenished quickly to set up the next elephant.  I wouldn't bet against Buffett/Berkshire being able to increase earnings significantly over the next 5-10 years.

 

There is no sign that earnings will not continue to grow at the double digit rate over the next 5 to 10 years. More likely to be a 15% growth rate, just by doing more of the same, nothing more clever.

 

 

[Txvestor]

Yes I think we can all agree my thinking on the total return was flawed.  I'll go back and edit the post to make things cleaner (and remove an embarrassing error ha).

 

Don't kick yourself too hard, because you will get more than 5-7% return even if the multiple holds - so good to try and factor in the following:

 

- BRK is providing no dividend right now, but it is safe to say the Buffett's minimal return on capital deployed is probably 10%.

- This means all retained earnings will eventually get deployed at 10% return minimum.

- You have retained earnings growing 5 -7 % which means that that amount that will be deployed at 10% is also growing.

 

The key with valuing BRK correctly, is to factor in that 10% return on new capital employed into your valuation.

 

The earnings yield is 7% right now - so you that is your base yield at these prices. To that you add new capital invested at 10%. So that means your answer has to be between 7-10% return. Now, having said that, if BRK also grows float, by say 2% a year and insurance is half the business, you might get an extra 1% with that. So we might say new capital may actually be invested at 11% - ie 10% + 1% from insurance float.

 

Basically if all new earnings were immediately invested in 10+1% opportunities, and the current multiple held, your return would be 11%. If none of those future earnings get invested ever, and because cash earns 0%, your return would be your 7% (or inverse of the p/e).

 

So your return is probably closer to 11% if you think Buffett will be able to continually deploy capital and 7% if he just sits on cash and doesn't ever pay a dividend.

 

Anyway, factoring the above in to your analysis will improve it.

 

Do you think Buffett is getting/going to get 10% on capital deployed? I doubt it, and one of the reasons i was surprised at the deal. I understood that he thought it was a good business but given the headwinds in Oil/Gas and China, and the numbers PCP was posting lately, surely $235 was a high price. I just wonder if this will outshine other investment opportunities he might have had coming down the pike. He will almost certianly have to hunker down for a couple of years to reload the elephant gun, and if those years happen to be turbulent, there will be missed opportunities.

[original mungerville]

Yes, I think he will get 10% (or damn close) otherwise he'll start paying a dividend or do buy-backs. In the recent past, every time he makes a big deal Burlington, Heinz, the latest one - everyone thinks he overpaid at first blush and then a few year later, it look like a steal.

 

That pattern is repeating itself with the latest one.

[rb]

Do you think Buffett is getting/going to get 10% on capital deployed? I doubt it, and one of the reasons i was surprised at the deal. I understood that he thought it was a good business but given the headwinds in Oil/Gas and China, and the numbers PCP was posting lately, surely $235 was a high price. I just wonder if this will outshine other investment opportunities he might have had coming down the pike. He will almost certianly have to hunker down for a couple of years to reload the elephant gun, and if those years happen to be turbulent, there will be missed opportunities.

I am a bit confused by your post, I can't figure out if you argue against the fact that BRK can get 10% returns in general or on PCP in particular.

 

In general it's not hard for BRK to get 10% returns on capital deployed. They can get 10-12% in BH Energy and that one is more or less guaranteed by the gov't. That business also has a long runway and a structural advantage over the competition. They could easily sink 100B in that business at 10% return over the next 10 years or so.

 

About PCP they stole the company. Not only they bought it way below value, PCP has a long runway too. They are one of those firms that can make critical components than no-one else can and those components go into very expensive applications. They have great materials technology and the future of industry is all about high tech materials. To use a very bad analogy PCP is like the Google of industry. And PCP will be way more valuable inside of BRK cause the management at PCP is great at doing acquisitions and now they have access basically to unlimited funds so BRK can double up by doing tuck ins at PCP.

 

Also oil and gas is a small part of PCP and the aircraft fleet is the oldest its ever been. So I don't understand what your concern about oil and gas or china is regarding BRK or PCP?

 

Like Original Mungerville says you'll see very clearly how he'll get >10% on PCP in the next several ARs. Stay tuned.

[Txvestor]

Do you think Buffett is getting/going to get 10% on capital deployed? I doubt it, and one of the reasons i was surprised at the deal. I understood that he thought it was a good business but given the headwinds in Oil/Gas and China, and the numbers PCP was posting lately, surely $235 was a high price. I just wonder if this will outshine other investment opportunities he might have had coming down the pike. He will almost certianly have to hunker down for a couple of years to reload the elephant gun, and if those years happen to be turbulent, there will be missed opportunities.

I am a bit confused by your post, I can't figure out if you argue against the fact that BRK can get 10% returns in general or on PCP in particular.

 

In general it's not hard for BRK to get 10% returns on capital deployed. They can get 10-12% in BH Energy and that one is more or less guaranteed by the gov't. That business also has a long runway and a structural advantage over the competition. They could easily sink 100B in that business at 10% return over the next 10 years or so.

 

About PCP they stole the company. Not only they bought it way below value, PCP has a long runway too. They are one of those firms that can make critical components than no-one else can and those components go into very expensive applications. They have great materials technology and the future of industry is all about high tech materials. To use a very bad analogy PCP is like the Google of industry. And PCP will be way more valuable inside of BRK cause the management at PCP is great at doing acquisitions and now they have access basically to unlimited funds so BRK can double up by doing tuck ins at PCP.

 

Also oil and gas is a small part of PCP and the aircraft fleet is the oldest its ever been. So I don't understand what your concern about oil and gas or china is regarding BRK or PCP?

 

Like Original Mungerville says you'll see very clearly how he'll get >10% on PCP in the next several ARs. Stay tuned.

 

OK fair enough. I was just asking because i guess I do not have that 2nd order thinking. If he does get all that right, that would be great, and i certainly have followed him long enough that I can't say it is not possible. However, I wasn't as bullish on PCP as that, and when i saw that he bought it at not far from a price it traded at for a 52 week high in light of recent business headwinds it seemed expensive. He himself said he paid up, which means he strongly believes in its future prospect cuz despite Charlie's influence, he remains a tight wad at heart. He certainly is not going to get 10% on the 30+ billion he has employed right away, but i guess time will tell if he can over the course of time.

[rb]

OK fair enough. I was just asking because i guess I do not have that 2nd order thinking. If he does get all that right, that would be great, and i certainly have followed him long enough that I can't say it is not possible. However, I wasn't as bullish on PCP as that, and when i saw that he bought it at not far from a price it traded at for a 52 week high in light of recent business headwinds it seemed expensive. He himself said he paid up, which means he strongly believes in its future prospect cuz despite Charlie's influence, he remains a tight wad at heart. He certainly is not going to get 10% on the 30+ billion he has employed right away, but i guess time will tell if he can over the course of time.

He always says he pays up for businesses and somehow they work out in a big way. I guess it's a better line than saying "We stole the company suckers!"

 

On the PCP front I think you'll be surprised. I've spent a lot of time researching this one so I can speak quite confidently. PCP is a highly coiled spring. Boeing and Airbus are looking to increase production at about 5-10% for the next couple of years. PCP prepared for that by investing in capacity and that built a lot of op leverage. The income should go up higher than that 5-10%. They've also had quite a bit of development costs for programs that are yet to come into full production like the XWB that are not going to re-occur. They've also had a headwind on the military part where basically the military ran down the inventory on spares to deal with the sequester ad other budgetary issues but that is also likely to reverse in the near future - at least if the military likes to keep its planes in the air.

 

So as you can see there is a lot of optionality built into the business that is about to pay off. The only downside is that they've built some capacity for oil and gas and orders are not coming in right now. But that is a small part of the business.

[jay21]

I think people need a stronger understanding of corporate finance when trying to estimate returns on capital deployed by BRK. For example in the PCP deal, if you arent considering the debt raised by BRK, you are making a mistake as the  leverage will increase the returns on equity.

 

A few other random things to consider:

 

1. Tax benefits and holdco leverage for the utility biz will move returns up to 13, 14, possibly 15%

2. A lot of people have mentioned that the earnings plus growth metric doesn't work because he retains all earnings to generate the growth. This is somewhat valid but doesn't consider the value he is creating that doesnt translate into earnings growth (e.g. buying equities). The right way to think about is something more like earnings growth + net change in securities/cash.

3. Low cost leverage - you see BRK buying IBM, preferreds, WFC, etc. You need to account for deferred taxes, insurance float, etc when thinking about capital allocation here. He may be getting a 8 - 12% return on those assets but its not all equity funding. (Also the preferreds are pretty cool in that they are taxed at 15% i think instead of corporate bonds being taxed at 40%)

4. Growth CapEx  (particularly BNSF) - this isnt all equity funded. Its why you might see return on capital of ~10% but the RoE is probably north of 15%.

 

Given the cash balance and overcapitalization, 10% is a conservative number but I wouldnt be surprised if the have another decade of growing IV in the teens.

[Guest longinvestor]

I think people need a stronger understanding of corporate finance when trying to estimate returns on capital deployed by BRK. For example in the PCP deal, if you arent considering the debt raised by BRK, you are making a mistake as the  leverage will increase the returns on equity.

 

A few other random things to consider:

 

1. Tax benefits and holdco leverage for the utility biz will move returns up to 13, 14, possibly 15%

2. A lot of people have mentioned that the earnings plus growth metric doesn't work because he retains all earnings to generate the growth. This is somewhat valid but doesn't consider the value he is creating that doesnt translate into earnings growth (e.g. buying equities). The right way to think about is something more like earnings growth + net change in securities/cash.

3. Low cost leverage - you see BRK buying IBM, preferreds, WFC, etc. You need to account for deferred taxes, insurance float, etc when thinking about capital allocation here. He may be getting a 8 - 12% return on those assets but its not all equity funding. (Also the preferreds are pretty cool in that they are taxed at 15% i think instead of corporate bonds being taxed at 40%)

4. Growth CapEx  (particularly BNSF) - this isnt all equity funded. Its why you might see return on capital of ~10% but the RoE is probably north of 15%.

 

Given the cash balance and overcapitalization, 10% is a conservative number but I wouldnt be surprised if the have another decade of growing IV in the teens.

 

+1. I would expect this to go on for longer than the next decade. Capital allocation is being done by others within BRK in 1-2-3-4 above. And they are are all more-of-the-same decisions. The PCP deal by Todd C is a prime example. So is the next Solar or Wind installation or buying more thicker gauge oil tank-cars from Marmon. Also, there are signs, early though, that the float is not flattening off or declining from $85 B. Ajit and the specialty insurance guys are ramping up big time.

 

They hate buying back their stock but have the 1.2x provision for future opportunities, to make it easy for the next CEO.

 

[thepupil]

 

2. A lot of people have mentioned that the earnings plus growth metric doesn't work because he retains all earnings to generate the growth. This is somewhat valid but doesn't consider the value he is creating that doesnt translate into earnings growth (e.g. buying equities). The right way to think about is something more like earnings growth + net change in securities/cash.

 

 

if one uses look through earnings (which is what the person who i responding to was using) is it not double counting to count both earnings growth and appreciation of stock prices?

 

the stocks appreciate because earnings grow over time.

 

For example, KO trades for $39 and is estimated to earn $2, it trades for 19.5X earnings. It pays a $1.32 divvy, 3.4% yield. Let's assume 6% growth in dividends and EPS over 10 yrs.

 

If I own 100 shares of KO

 

look through earnings            = $200

pre-tax investment income is  = $132

 

My total return over the next 10 yrs (with no multiple change and 6% growth and divvy's reinvested*) will be 9.6%.

 

If you say that the total return is look through earnings of $200 (5.1% earnings yield) + growth in EPS of 6%, it overstates the return because some of the non-dividended earnings are being used to repurchase shares and invest in growth to fuel the EPS growth.

 

If you use "earnings growth + net change in securities/cash", then you have to not use look through earnings. In our KO example if you use look through earnings the total growth in value of KO would be 6% (earnings growth) + 6% (capital appreciation of KO) = 12%.

 

Isn't that double counting and won't that overstate intrinsic value growth? If you use investment income (rather than look through earnings) then you can also count the capital appreciation.

 

Now I will say that all this theoretical gobbledygook is ignoring multiple change. Mr. Buffett is not afraid to monetize his changes in multiples via tax efficient swaps (Duracell/PG, WaPo transaction, Phillips 66 thing, etc.). So I'm not saying he won't take advantage of a re-rating in the value of an owned security (or a business like Heinz, which 3G and team got all dressed up for the ball and bought a shit ton of Kraft with their re-rated and arguably quite expensive Heinz).  In the cases where Buffett takes advantage of re-rating, then the total return is indeed greater than investment income + earnings growth.

 

I love berkshire and think it will provide a nice return, particularly relative to the S&P, but just trying to keep expectations of the stock portfolio realistic.

 

*I realize berkshire never reinvests divvy's, this is for simplicities sake. It can also be reinvested at whatever you think berkshire will make over time

[vinod1]

Agree with thepupil regarding growth. Growth in book value anywhere near teens is unlikely.

 

I did a detailed write up on BRK in early 2010 and did an update and postmortem on where my estimates have deviated from actual results. None of the growth factors have changed all that much over the past 5 years, except that equity portfolio is more likely to have lower returns going forward than in the past years.

 

Here is the section:

 

Over the last 5 years (from 2009 YE to 2014 YE), Berkshire has compounded shareholders equity from $131 billion to $240 billion, at a compound annual rate of 12.9%. I had estimated in early 2010 that shareholders equity is likely to compound at about 9.6% to $207 billion. Shareholders equity increased by $33 billion more than my estimate. What happened?

 

I underestimated growth in two segments

 

1. Equity Investment Returns: Berkshire had an equity portfolio of $57 billion at 2009 YE. I estimated a price return (excluding dividends) of 6% on equity portfolio. Actual S&P 500 price return (excluding dividends) over the same period is 13.0%. If Berkshire equity portfolio matched S&P 500 returns, equity portfolio would be $105 billion at end of 2014, compared to my estimate of $76 billion. This accounted for $29 billion of the underestimate.

 

2. BNSF Earnings: I estimated earnings over the last 5 years of about $10 billion. BNSF reported earnings of $16 billion over this period. This accounted for $6 billion of the underestimate.

 

My estimates for underwriting profits, investment income, annual gains from investments (equities, bonds, preferred stocks, etc.), and financial products earnings are close to actual results. Utilities and Manufacturing, Service & Retail came in above my estimates but not significantly.

 

If equity returns instead averaged 7% over the last 5 years, book value would have compounded at 10.4% annually instead of 12.9%.

 

Going forward I think it is more likely that growth rate would be between 9% to 10%.

 

Vinod

[jay21]

Sorry - missed the look through part. Agree except it does not account for cash and fixed income balance changes (not sure if you are counting warrants and preferreds as well). Also with Ted and Todd managing a portion of the portfolio, there will be some monetization of security changes (i.e. they will be opportunistic relative to Warren).

 

Also agree that 10% is a good conservative return estimate. I think that if Warren wanted to be more aggressive with the balance sheet, then low teens would be easy and he may even do better but it seems like the company isnt shooting for the stars anymore.