BRK Valuation

[Thrifty3000]

He doesn't get it. But it's a nice demonstration of commitment bias.

 

^This is why you have no friends. No no, your grandpa doesn’t count.

 

I think you meant confirmation bias, which Munger shorthands as commitment/consistency.

[jfan]

You can play with the #s however you like, the point is that companies which can grow earnings without reinvesting capital (and therefore can distribute it to owners) are much more valuable.

 

It's taken me a while but I finally got my head around this concept. I've read through the Stephen Penman accounting textbook and his use the residual earnings model. I think this model hides the exact issue that others have been raised up,  freely distributable earnings (today) that don't need to be reinvested for growth (aka FCF, owner's earnings, cash from operations less maintenance capex, etc) is very different than earnings that need to be retained in the business for future growth (eg expansion of inventory and accounts receivables, PPE, etc).

 

I'll share with everyone my mistakes and what the lessons were:

1) Linamar - The net income of the business was growing year over year 10-15%, with an ROE of 15-20% before all the trade war stuff. However, what I failed to realize was that while it look quite good using a Penman's residual earnings model, it failed to account for the fact that in order for it to grow, it would need to take those cash earnings and reinvest all of it to working capital and capex in order to grow the next year, leaving very little free cash flow to could be distributed to me. I was not until the business started shrinking, that free cash flow (owner's earnings) was then able to be distributed via share buybacks, its meager dividend, and paying back debt.

 

2) Missing out on Amazon (or substitute a SAAS business, advertising agencies, insurance companies, Costco (to some degree)  etc). I remember telling a colleague that Amazon is not profitable. It's net income margins are so slim, so what if it is growing revenues, it's too pricey. What I failed to realize was that by creating a marketplace with a feedback loop on supplier and buyer dynamics, it was able to receive payments from buyers before having to pay suppliers and able to grow on the backs of the supplier's money without having to put up its own capital. Then layer  on the prime membership, and now it was receiving prepayment of customer's money even before providing any service. So in essence, Amazon was able to grow by using other people's money and as a result generating massive amounts of distributable cash. This potentially distributable cash was reinvested for more growth in other areas but it could have been easily paid out as a dividend or share buybacks.

 

So it only makes sense that Amazon is much more valuable than Linamar.

 

I guess if you can make an argument that BRK could grow 6% per year WITHOUT needing to retain its cash earnings, then BRK could be creating value for shareholder. If BRK needs alot of its cash earnings to reinvest in working capital and PPE in order to grow the cash earnings the year after by 6%, then BRK would be destroying value for shareholders.

 

I think the nuance is in the definition of what you exactly mean by owner's earnings and how you parse out growth expenditures.

 

 

 

[DooDiligence]

He doesn't get it. But it's a nice demonstration of commitment bias.

 

Textbook example.

 

I like the way he escalates the commitment & projects his own friendlessness on you.

[LC]

Right- and this is one of the big benefits of pricing power. Cigarettes are a prime example of this but there are certainly others.

 

In fact this is where Thrifty is actually somewhat on point - not many companies have tons of opportunities to re-invest lots of capital for growth. The utilities, the railroad, even the insurance ops provide built-in reinvestment opportunities. And (at least for the first two) the return is relatively stable. Actually it provides WB with an option: If he can't find super attractive uses for $$, he can always dump some into the heavy businesses. What is the value of a perpetuity-like reinvestment option?

 

To the other point, I don't think Berkshire is investing below its cost of capital i.e. engaging in value destruction. If your personal hurdle rate is 25% for example then BRK is probably not where you want to put your money.  ;D

[Thrifty3000]

Right- and this is one of the big benefits of pricing power. Cigarettes are a prime example of this but there are certainly others.

 

In fact this is where Thrifty is actually somewhat on point - not many companies have tons of opportunities to re-invest lots of capital for growth. The utilities, the railroad, even the insurance ops provide built-in reinvestment opportunities. And (at least for the first two) the return is relatively stable. Actually it provides WB with an option: If he can't find super attractive uses for $$, he can always dump some into the heavy businesses. What is the value of a perpetuity-like reinvestment option?

 

To the other point, I don't think Berkshire is investing below its cost of capital i.e. engaging in value destruction. If your personal hurdle rate is 25% for example then BRK is probably not where you want to put your money.  ;D

 

I feel like I’m in bizarro world. If your hurdle rate is 25% then buy Berkshire at a low enough price to yield 25%. (Spoiler alert, that won’t happen since company buybacks set a floor well above said price.)

[LC]

Yes, obviously. And if Brk-A trades at $1/share you should also purchase it.

 

In reality it trades at a 6% yield which is why I said, "if your hurdle rate is 25% then you should be looking elsewhere."

[Thrifty3000]

Sadly, nobody is offering opinions of Berkshire’s valuation.

 

Further, we seem to be having some sort of a debate over whether the retained earnings of Berkshire’s operating companies and equity investments are valuable and growing. (I’m of the opinion they are both valuable and growing.)

 

And, there seems to be some degree of general disdain over a private investor’s desire to discount those earnings at a rate greater than the rate he estimates those earnings will grow when he is establishing his own desired purchase price.

[longterminvestor]

Personally, I’m concerned the company isn’t being handed over to “leaders.” I think it’s being handed off to managers. There’s a big difference.

 

On the positive front you have Ajit and Todd. Ajit is the real deal when it comes to insurance. And, I’m generally excited about the prospects of capital being deployed by Todd Combs, as I get a sense he can learn to be as shrewd as Buffett.

 

I think Ted and Greg, however, are faking it until they don’t make it.

 

No manager will grasp Berkshire or the investment world the way Buffett did in his prime - when it was easier to grow. And, none of the next generation of senior management has shown any ability to communicate like a leader (David Sokol was the closest - but awkwardly arrogant). I suspect they will communicate like operators not wanting to screw up. And, thus begin the journey toward bigness and dumbness.

 

Thrifty3000 - thanks for sharing.  All opinions/thoughts are welcome even if some are not well received.  I am curious on your comment above regarding Ajit/Todd and Gregg/Ted.  Ajit is hands down wonderful insurance man however he may not be as long lived as we all want.  Pray he is grooming a deep bench.  Todd is doing just fine.  Don't agree with comment on Gregg - you believe he does not have "the right stuff"?  Please expand.  I was very impressed with his tone/candor during meeting and believe he can allocate capital very well.  Ted is gonna do just fine as well.

 

With regards to management taking over, I think its easier than people think.  I believe new management's charge from BOD will be to "not make a big mistake" rather than "grow earnings at XX%/yr".  Basically Gregg will sit in the Ivory tower with Tedd/Todd (or Gregg has his own lieutenants) and WAIT for 10-12% year 1 return to deploy significant capital.  WAITING is the discipline.  Only difference will be Gregg is gonna have a spreadsheet to do calculations where Mr. Buffett calculates in his head real time. And Mr. Buffett is leaving Gregg/Tedd/Todd 2 ACES to play when no opportunity is available: #1 Buybacks & #2 Dividend. 

 

The tone of Thrifty3000 post is assuming WAITING = DUMBNESS.  I very much disagree, waiting is the ENTIRE GAME!!!  No one else waits, they all scour the earth for 10%-12% returns and when they see nothing is available they reduce expectations to 6%/8% or even 3%/5% and say "well, if we lever that - we will get 10%/12%".  I mean, VC's and PE Groups are now investing in Copywrite Vehicles that own music to license to for commercial use - wow have we reached a new level of creativity looking for yield.  Could be a wonderful business, I have no opinion however the point is "Helpers" will find or manufacture vehicles for investment to give the yield market needs to feed itself.  Idiots, all of them!  and ssssshhhhhhh - dont tell them.  BRK will pick the bones of their dead carcasses and now the return will be 15%/17%!!!

 

 

 

[vinod1]

Sadly, nobody is offering opinions of Berkshire’s valuation.

 

Further, we seem to be having some sort of a debate over whether the retained earnings of Berkshire’s operating companies and equity investments are valuable and growing. (I’m of the opinion they are both valuable and growing.)

 

And, there seems to be some degree of general disdain over a private investor’s desire to discount those earnings at a rate greater than the rate he estimates those earnings will grow when he is establishing his own desired purchase price.

 

Hi Thrifty3000,

 

You mentioned a lot of good points and obviously very smart and knowledgeable.

 

A lot of the board members are providing you with good advice. I made a very similar mistake in the past until I realized why there is no earnings discount model. I wish I wrote something that caused fellow board members to point out my mistake. Then I would have corrected it earlier.

 

You are lucky!

 

Here we are disagreeing with some very basic financial math. There is not much to disagree on if one understands it. I say it with nothing but goodwill and regards for you.

 

Vinod

 

[vinod1]

I will try one simple exercise to see if it conveys the point. Forget all the earnings models.

 

Assume BRK has $10 normalized earnings last year. Retains all earnings and does not pay dividends.

 

It grows at 5% for 50 years to $115 EPS in 2070.

 

It sells at a PE of 25 or $2875 in 2070.

 

So if you buy BRK today at $160 (a PE of 16), you would end up earning 6% total return.

 

The PE increase contributed adding only 1% to the return. Earnings growth per share drives the return. You cannot have vastly different earnings growth and share price growth without PE blowing out to an extreme.

 

If you want 10% returns from BRK assuming above, you need to buy it at $25 per share. A PE of 2.5.

 

Vinod

[vinod1]

You can play with the #s however you like, the point is that companies which can grow earnings without reinvesting capital (and therefore can distribute it to owners) are much more valuable.

 

Ok, I totally agree with you there. I feel like that’s where my 6% growth assumption comes into play. I’ve seen growth assumptions from others as high as 8.5%.

 

But, I’m pretty sure Buffett would not have stopped buying back shares in Q1 if he thought long term growth of 8.5% was feasible.

 

I model out for 7 years. So my forecast is over the next 7 years starting from end of March 31. BRK portfolio had slightly higher expected returns from the prices on March 31 and it providing a bit of tailwind from re-rating over 7 years.

 

The 8.5% is not from here to eternity.

 

I did a valuation for YE 2009 and my estimates for 10 year, BV and price. See below. I then reconcile every 5 years to see why it differed. I had not put up the reconciliation on my website. But the main book value growth difference is from (1) tax cut changes (2) portfolio returns.

 

http://vinodp.com/documents/investing/BerkshireHathaway.pdf

 

Vinod

[sleepydragon]

What is a good book to read on this subject?

Thanks!

[vinod1]

What is a good book to read on this subject?

Thanks!

 

Hands down Investment Valuation: Tools and Techniques for Determining the Value of any Asset by Aswath Damodaran. Spent several months on this. This is after I passed all the CFA exams. It just goes into all the nitty gritty that is not covered well elsewhere. Some prefer McKinsey's Valuation book.

 

https://www.amazon.com/dp/1118130731/ref=pd_bxgy_3/137-5938580-2840858?_encoding=UTF8&pd_rd_i=1118130731&pd_rd_r=5dc816ca-cf6a-4875-869b-211f186b1995&pd_rd_w=jTwQ7&pd_rd_wg=igTPH&pf_rd_p=4e3f7fc3-00c8-46a6-a4db-8457e6319578&pf_rd_r=NCA2HZFBPWA29D8W148Y&psc=1&refRID=NCA2HZFBPWA29D8W148Y

[sleepydragon]

What is a good book to read on this subject?

Thanks!

 

Hands down Investment Valuation: Tools and Techniques for Determining the Value of any Asset by Aswath Damodaran. Spent several months on this. This is after I passed all the CFA exams. It just goes into all the nitty gritty that is not covered well elsewhere. Some prefer McKinsey's Valuation book.

 

https://www.amazon.com/dp/1118130731/ref=pd_bxgy_3/137-5938580-2840858?_encoding=UTF8&pd_rd_i=1118130731&pd_rd_r=5dc816ca-cf6a-4875-869b-211f186b1995&pd_rd_w=jTwQ7&pd_rd_wg=igTPH&pf_rd_p=4e3f7fc3-00c8-46a6-a4db-8457e6319578&pf_rd_r=NCA2HZFBPWA29D8W148Y&psc=1&refRID=NCA2HZFBPWA29D8W148Y

 

Vinod, thank you very much!

I read a smaller book by him before and it was pretty good.

[aryadhana]

You may also want to check out John Burr Williams' "Theory of Investment Value" (1938, Amazon).  There's a cogency to the way he writes, and I'm not sure we've substantively advanced our conceptual understanding of valuation by much since then. 

 

I'm not sure what the argument against initiating dividends paying out even just a fifth of earnings really is.  I'm not even really sure that "taxes" is the right answer.  We can all hold stock and treasuries on our person without paying any corporate tax.  A dividend would also enable them to methodically reason about share repurchases: how much in future dividend payouts are saved by repurchasing at this price or, similarly, by how much more can we accelerate dividends paid per share given this repurchase? 

 

Should they even have a sizable investment portfolio? 

[Thrifty3000]

You can play with the #s however you like, the point is that companies which can grow earnings without reinvesting capital (and therefore can distribute it to owners) are much more valuable.

 

Ok, I totally agree with you there. I feel like that’s where my 6% growth assumption comes into play. I’ve seen growth assumptions from others as high as 8.5%.

 

But, I’m pretty sure Buffett would not have stopped buying back shares in Q1 if he thought long term growth of 8.5% was feasible.

 

I model out for 7 years. So my forecast is over the next 7 years starting from end of March 31. BRK portfolio had slightly higher expected returns from the prices on March 31 and it providing a bit of tailwind from re-rating over 7 years.

 

The 8.5% is not from here to eternity.

 

I did a valuation for YE 2009 and my estimates for 10 year, BV and price. See below. I then reconcile every 5 years to see why it differed. I had not put up the reconciliation on my website. But the main book value growth difference is from (1) tax cut changes (2) portfolio returns.

 

http://vinodp.com/documents/investing/BerkshireHathaway.pdf

 

Vinod

 

Vinod, I sincerely appreciate your generous advice and look forward to reviewing your valuation. Thank you.

[sleepydragon]

Thrifty,

I think when you use ROE, people get to valuation represented by a multiple of the book value. The higher roe the higher multiple.

If you mix roe and DCF model, you need to make sure you separate the FCF from earning to do DCF. So in your spreadsheet, you use ROE to get the earnings, you then deduct capex (and dividends), and then DCF on the FCF/retained earning.

 

Actually I think a better way for valuations is do comparables.

For BRKb, we can compare BRK against UNP, XLU, progressive and then just take the market value of the portfolio. I believe if we take brk’s revenue segmentation weighted YTD market price returns of the peer companies of BRK’s biggest component’s, we will find BRK is lagging by at least 20% YTD.

 

[sleepydragon]

You may also want to check out John Burr Williams' "Theory of Investment Value" (1938, Amazon).  There's a cogency to the way he writes, and I'm not sure we've substantively advanced our conceptual understanding of valuation by much since then. 

 

I'm not sure what the argument against initiating dividends paying out even just a fifth of earnings really is.  I'm not even really sure that "taxes" is the right answer.  We can all hold stock and treasuries on our person without paying any corporate tax.  A dividend would also enable them to methodically reason about share repurchases: how much in future dividend payouts are saved by repurchasing at this price or, similarly, by how much more can we accelerate dividends paid per share given this repurchase? 

 

Should they even have a sizable investment portfolio?

 

Thanks! I will check it out

[Thrifty3000]

You can play with the #s however you like, the point is that companies which can grow earnings without reinvesting capital (and therefore can distribute it to owners) are much more valuable.

 

Ok, I totally agree with you there. I feel like that’s where my 6% growth assumption comes into play. I’ve seen growth assumptions from others as high as 8.5%.

 

But, I’m pretty sure Buffett would not have stopped buying back shares in Q1 if he thought long term growth of 8.5% was feasible.

 

I model out for 7 years. So my forecast is over the next 7 years starting from end of March 31. BRK portfolio had slightly higher expected returns from the prices on March 31 and it providing a bit of tailwind from re-rating over 7 years.

 

The 8.5% is not from here to eternity.

 

I did a valuation for YE 2009 and my estimates for 10 year, BV and price. See below. I then reconcile every 5 years to see why it differed. I had not put up the reconciliation on my website. But the main book value growth difference is from (1) tax cut changes (2) portfolio returns.

 

http://vinodp.com/documents/investing/BerkshireHathaway.pdf

 

Vinod

 

Awesome analysis, Vinod. It looks like your valuation and advice were spot on. I liked how you segmented your intrinsic valuation into investment value vs speculative value.

 

I did notice something interesting when I compared the output of your approach to mine.

 

Your approach resulted in a total intrinsic valuation of $110 per B share (in 2009).

You advised that investors would earn a 9% to 10% return if they purchased B shares at a price of $84 per share.

You advised that aggressive investors should invest at $67 per share.

And, you estimated look through earnings of $4.90 per B share.

 

Now, the funny thing is that when I plug $4.90 earnings and 9% growth into my humble little discount-based model it spits out the following:

 

Intrinsic value per B share: $108.88 (Difference from Vinod's model = $1.12 or 1%)

Recommended purchase price at 40% discount to Intrinsic Value: $65.33 (Difference from Vinod's model = $1.67 or 2.49%)

And, if I had purchased shares in 2009 at $65.33 per share I would have experienced compound growth of approx. 10%. Not too bad.

 

(Side note: Uh Oh! Thrifty3k might be on to something!)

 

It still feels like getting the look through earnings and growth estimates right are the most important factors. Oh yeah, and purchase price. I'll post how I arrive at look through earnings in a bit.

[Thrifty3000]

Thrifty,

I think when you use ROE, people get to valuation represented by a multiple of the book value. The higher roe the higher multiple.

If you mix roe and DCF model, you need to make sure you separate the FCF from earning to do DCF. So in your spreadsheet, you use ROE to get the earnings, you then deduct capex (and dividends), and then DCF on the FCF/retained earning.

 

Actually I think a better way for valuations is do comparables.

For BRKb, we can compare BRK against UNP, XLU, progressive and then just take the market value of the portfolio. I believe if we take brk’s revenue segmentation weighted YTD market price returns of the peer companies of BRK’s biggest component’s, we will find BRK is lagging by at least 20% YTD.

 

I use Look Through Earnings, which are the earnings that would be available to owners if all free cash flow generated by the operating companies and equity holdings were distributed instead of retained.

 

I assume every dollar retained will lead to at least a dollar of market value over time.

[Thrifty3000]

How I derive Berkshire’s Look Through Earnings

 

Based on 2019 Earnings (In Billions USD except per share info)

 

Non-Insurance Business Earnings: $17.7

 

Less CapEx Adjustment (Maintenance CapEx less Depreciation): $3

Plus Acquisition-related Amortization: $1.3

 

TOTAL ADJUSTED NON-INSURANCE BUSINESS EARNINGS: $16

—————————————————————————————————

 

Equities

 

Dividends: $4

Estimated Equity Retained Earnings: $9

 

TOTAL EQUITIES LOOK THROUGH EARNINGS: $13

—————————————————————————————————

 

TOTAL SHARED HOLDINGS EARNINGS (Kraft-Heinz, Berkadia, Flying J): $1

 

EARNINGS FROM TREASURIES & CASH EQUIVS (Assume 1% yield. #lazy): $1.25

 

INSURANCE COMPANIES (After tax operating profit - I think Buffett ignores this): $.325

 

TOTAL LOOK THROUGH EARNINGS: $32 BILLION

 

Average Equivalent B Shares Outstanding (3/31/2020): 2,434,333,367

 

LOOK THROUGH EARNINGS PER B SHARE: $12.97

 

Post-Covid New World Order 20% Impairment (#reallyLazy): $10.37 per B share

[handycap5]

Chris Bloomstran on a recent interview put the normalized earnings power at $40 billion. Any idea of where he gets that figure?

 

 

[Cigarbutt]

You may also want to check out John Burr Williams' "Theory of Investment Value" (1938, Amazon).  There's a cogency to the way he writes, and I'm not sure we've substantively advanced our conceptual understanding of valuation by much since then. 

 

I'm not sure what the argument against initiating dividends paying out even just a fifth of earnings really is.  I'm not even really sure that "taxes" is the right answer.  We can all hold stock and treasuries on our person without paying any corporate tax.  A dividend would also enable them to methodically reason about share repurchases: how much in future dividend payouts are saved by repurchasing at this price or, similarly, by how much more can we accelerate dividends paid per share given this repurchase? 

 

Should they even have a sizable investment portfolio?

The book is available here:

https://archive.org/details/in.ernet.dli.2015.225177/page/n1/mode/2up

If anything, the book is interesting for historical reasons and investing work still basically comes down to somehow imagining future cashflows and using an appropriate discount factor. The emphasis on dividends has changed and Mr. Burr Williams hoped that investment analysis may eventually help to reduce the damage done by the cycle. i wouldn't bet on that.

 

Chris Bloomstran on a recent interview put the normalized earnings power at $40 billion. Any idea of where he gets that figure?

i haven't heard (or read) Mr. Bloomstran lately but it may be related to what he wrote in his last annual letter (p113, adjusted net income,economic earnings)

https://static.fmgsuite.com/media/documents/c388840b-3dda-41da-a062-077bf785255b.pdf

[Thrifty3000]

Yes. He lays everything out in great detail in his annual letters/novellas. He makes several more accounting adjustments than Vinod and I do for things like pension liabilities, etc.

 

He makes assumptions that a large percentage of the cash will be invested at higher rates of return over time (a safe bet), and incorporates the higher projected earning power into “normalized” earnings.

 

Due to his accounting adjustments and assumptions his pre-covid normalized earnings came in about $8 billion higher than my pre-covid estimate. If you assume $100 billion of cash will eventually be invested at an 8% to 10% return, and discount it a bit to account for the wait time to deploy, it accounts for much of the difference between his estimate and mine. I'm a wuss when it comes to optimistic forecasts, so I prefer to assume more cash will pile up at the same rate existing cash will be deployed (see next paragraph).

 

If I recall correctly he also assumes a higher growth rate than I do. I believe his pre-covid estimate gravitated towards 8%. I’m trying to talk myself into using a 7% rate, but I’m not there yet. The cash will be a huge drag. They have to invest $30 billion and growing annually in expensive large cap equities, expensive private companies, or their own fairly priced shares. Remember, BNSF “only” cost $26 billion. I just can’t be optimistic about BRK being able to make a BNSF sized acquisition at a decent price every single year going forward, which is pretty much what it will take to sop up the free cash pouring in (cry me a river). (Buffett says his circle of competence encompasses about 5% of businesses. If you assume he’s comfortable evaluating/purchasing 5% of the businesses in the world, which are at least as big as BNSF, that doesn’t leave many.)

 

I do look forward to Bloomstran’s analysis of covid’s impact on the various segments, if for no other reason than trying to forecast how things like negative interest rates will impact every insurance and banking operation; how less travel will impact airline and auto related businesses, etc, etc, etc - a gargantuan undertaking, and WAY above my pay grade (probably above Bloomstran’s pay grade, and maaaybe above Buffett’s, seeing as he went to DEFCON 1 in March). That’s why I just lop 20% off my pre-covid estimate (#lazy #tooHardPile).

 

 

[widenthemoat]

I'm not saying it isnt cheap (and I'm long) but if you count the equities you are implicitly including a bunch of the value of the insurance. There were over $160 B in liabilities related to the insurance operation last quarter. I get the concept of float, but I think treating that as equity (vs a long term cheap loan) is an aggressive way to think about it.

 

If you wanted to sell the insurance cos without their financial assets but with their policy liabilities, you'd be sending a bunch of money out the door to get someone to take them.

 

bizaro86, not taking a shot at your thoughts on the float liability, but rather want to see if you can poke holes in how I think about it. I'll use a hypothetical company that is 100% capitalized by float as my example. Let's assume we issue a $1.0m policy at the beginning of every year that gets paid out at the end of the year. We take that $1.0m and invest it into Treasury bills at a 10% rate (day-dreaming over here, I know). Well at the end of the year we would have $0.1m in the bank, $1.0m in a Treasury bill, receive cash inflows of $1.0m for the new policy issued, and pay out $1.0m of insurance claims/expense for the beginning of the year policy (assuming cost of float is zero). In this situation, the equity holder would be able to receive a dividend of $0.1m, unencumbered by the float liability. We can have this same situation occur forever into perpetuity, collecting $0.1m every year. My question becomes, why knock something off of the equity value if we never have to truly pay back the float and it doesn't cost anything in interest? That's $0.1m in my pocket every single year, just as if I funded the company 100% with my own money.