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Is Berkshire's book value artificially low and if so, what are the mechanics behind this?


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Is it due to the way the capital base is structured?

 

I understand the zero cost "float" which Omaha gets to invest, and I get how a lot of this "money" does not belong to BRK, but to future claimants.

 

I get the advantage of the holdco structure, which allows Omaha to redeploy cash from subs which have little or no reinvestment opportunities, to those which can reinvest at higher ROI's.

 

I can see how breaking Berkshire up and spinning subs would rerate them at higher multiples, but might also trigger a tax burden that some argue would offset the gains. I have my doubts about this, but I don't doubt the disadvantage that some businesses would have due to being cut off from zero cost financing due to Berkshires ability to move cash around where it's warranted.

 

My "semi-autist" confusion comes in not understanding why Berkshire trades barely above book while P/E and FCF yields look fair for the overall business. Is book value artificially low due to the capital structure or is there some other reason? Did I already answer my own question but fail to connect the dim witted dots?

 

There are those (I think they're either idiots or hucksters), who deride Omaha's performance. I started looking at Berkshire back in 2010, when the price was around $70/sh., and look where the assets, IV and equity price are now (just a mere 12 years later).

 

Full disclosure: I am NOT a finance pro (obviously), and BRK is a bit over 16% of my portfolio.

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  • DooDiligence changed the title to Is Berkshire's book value artificially low and if so, what are the mechanics behind this?

Yes, no, maybe?

BV is low if you think FV is higher.

How do you estimate FV? Well if you are using BV, then you're just running in circled 🙂 

 

The real question is what is the best method to determine fair value. Personally I think BV is antiquated and mostly useless and I don't understand why analysts use it to estimate FV for Berkshire and such. 

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6 minutes ago, LC said:

Yes, no, maybe?

BV is low if you think FV is higher.

How do you estimate FV? Well if you are using BV, then you're just running in circled 🙂 

 

The real question is what is the best method to determine fair value. Personally I think BV is antiquated and mostly useless and I don't understand why analysts use it to estimate FV for Berkshire and such. 

 

In a semi-traditional sense, BV should reflect what's left over in an orderly liquidation. Berkshire is obviously an ongoing concern.

 

The replacement value of BRK's individual businesses is not reflected in BV and I'm curious if, and how much, hidden value exists based on the assets.

 

I'm also trying to figure the factors that keep BV so low in comparison to other metrics, which seem reasonable based on the business. I've been reading through old BRK threads and think I kind of understand, and I should probably just forgo the mental accounting gymnastics.

 

If more members with bonafide street cred (you are one such individual), responds with, "just keep adding, never sell and be happy", I'll drop the subject.

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How much accounting do you enjoy? 

 

I buy an asset in 1950 for $50. I depreciate it over 70 years down to Zero. BV = 0

Today that asset earns $10/year.  FV = Greater-Than-0

The See's Candy story.

 

That's generally the jist of it. Unless you are marking you assets to market (which may or may not be appropriate - depends on the asset), your BV will be a historical figure and not a current one. This is why you see one-time write offs for good will and such, and there is some loosey-goosey playing around that management can do.

 

Remember when Berkshire wrote down Heinz's book value? It took them a few years to "determine the asset was impaired".

Meanwhile the market knew it after a few months. 

 

How accurate BV is depends on a lot of things, including the capital-intensity of the business, accounting laws, and management's incentives.

 

 

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7 minutes ago, LC said:

How much accounting do you enjoy? 

 

I buy an asset in 1950 for $50. I depreciate it over 70 years down to Zero. BV = 0

Today that asset earns $10/year.  FV = Greater-Than-0

The See's Candy story.

 

That's generally the jist of it. Unless you are marking you assets to market (which may or may not be appropriate - depends on the asset), your BV will be a historical figure and not a current one. This is why you see one-time write offs for good will and such, and there is some loosey-goosey playing around that management can do.

 

Remember when Berkshire wrote down Heinz's book value? It took them a few years to "determine the asset was impaired".

Meanwhile the market knew it after a few months. 

 

How accurate BV is depends on a lot of things, including the capital-intensity of the business, accounting laws, and management's incentives.

 

 

 

I forgot what happens when you offer a permanent home for businesses.

 

image.gif.f2f7e9129aa830cf08bf925c55d09f26.gif

 

I'll just enjoy my slice of Omaha.

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20 hours ago, LC said:

How much accounting do you enjoy? 

 

I buy an asset in 1950 for $50. I depreciate it over 70 years down to Zero. BV = 0

Today that asset earns $10/year.  FV = Greater-Than-0

The See's Candy story.


 

It used to be the case that you could write down goodwill, but that’s not true any more. Goodwill now only gets written off when it does not pass the impairment test. Other intangibles (like customer lists) still can be written off.

The ghist or your post is still true. If you buy a high ROIC business, most of your Purchase price is goodwill. if this business keeps growing, Goodwill still will remains the same, only the smallish tangible part of invested capital will grow.

 

Simple example - you bug a business for $5B and it earns $250M, You pay $4B for intangibles and $1B for tangible assets. Business growths and doubles in size over a couple of years. If everything remains the same, then your tangibles will have doubled too, to $2B  but intangibles remains the same at $4B

So now you own a business that is valued on  your balance sheet for $6B and that makes $500M in earnings (assume that earnings have doubled as the business size did).

 

The key of course is that the business keeps growing after you buy it. PCP for example didn’t do this and that’s why goodwill was written down as it didn’t pass the impairment test one year.

Edited by Spekulatius
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Would this make a decent summation of the reasoning behind artificially low BV, and the case for not breaking BRK up?
 

A big factor in Berkshires low BV appears to be due to its commitment to offer permanent homes to businesses. Many subs have been owned for a very long time (Sees, Clayton, GEICO, etc.), and are heavily depreciated on the books. IOW, they’re worth a lot more than the value they’re held at (grammar police please).
 
https://en.wikipedia.org/wiki/List_of_assets_owned_by_Berkshire_Hathaway  -  (a good quick reference list with purchase dates.)
 
Allowing insurance subs to hold equities (part of the zero cost "float" which they get to invest, while knowing they'll have to pay a large portion out in claims at some point). WEB knows that this "money" does not belong to BRK, but to future insurance claims against GEICO, General RE, National Indemnity. Some of these equities have been held for a very long time. I haven’t tried to figure out how recent mark to market rules affect the balance sheet but I’m guessing it causes them to reflect current value on the books. I know there are revolving tax consequences and this rule seems like a great way to muddy the waters to no good purpose.
 
Aside from the book value discussion, a big advantage of the holdco structure is that they get to redeploy cash from subs which have little or no reinvestment opportunities, to those which warrant it and can reinvest at higher ROI's. As assets grow, and they will, the overall intrinsic value will also grow.
 
Breaking Berkshire up would spin out subs at much higher multiples but would also trigger a tax burden that would partially offset the gains. I have my doubts about how significant the offset would be, but I don't question the disadvantage that some businesses would be put due to being cut off from zero cost financing with Berkshires ability to move cash around where it's needed. There’s a significant bit of magic in this.
 
Critics be damned. I started looking at Berkshire back in 2010, when the price was around $70/sh., and look where it is now a mere 12 years later. Not a bad deal!
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10 hours ago, Spekulatius said:

The key of course is that the business keeps growing after you buy it. PCP for example didn’t do this and that’s why goodwill was written down as it didn’t pass the impairment test one year.

 

How long do they have to see this? What if it turns around say 10 years later and earnings double or triple, do they write back the goodwill?

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40 minutes ago, scorpioncapital said:

 

How long do they have to see this? What if it turns around say 10 years later and earnings double or triple, do they write back the goodwill?

No, they would not write back the goodwill if PCP as a business improves.

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Book value is still a reasonable proxy (input or else) for valuation.

The See's example is not exactly meaningful as the profits realized are kept in retained earnings for the whole and are reinvested.

Book value still has value especially for insurance companies, banks, utilities etc.

Fairfax has had a page in the early part of annual reports showing, side by side, the changes in book value vs stock price and, especially if you adjust for the change in exchange rates (the USD has been appreciating against CAD for a while now and more lately), the rates of growth are similar when looking from a longer term perspective although year-to-year variations can be very significant.

Mr. Bloomstran had an interesting (and relevant?) section a few short years ago (pages 51-60):

b8622c94-d42e-453d-bb67-3898a17a14c4.pdf (fmgsuite.com)

He makes the point that paying for book value (and holding for a while) will result in you earning the return on equity + or - the change that may occur in the price-to-book multiple.

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On 10/11/2022 at 9:22 PM, Cigarbutt said:

Book value is still a reasonable proxy (input or else) for valuation.

The See's example is not exactly meaningful as the profits realized are kept in retained earnings for the whole and are reinvested.

Book value still has value especially for insurance companies, banks, utilities etc.

Fairfax has had a page in the early part of annual reports showing, side by side, the changes in book value vs stock price and, especially if you adjust for the change in exchange rates (the USD has been appreciating against CAD for a while now and more lately), the rates of growth are similar when looking from a longer term perspective although year-to-year variations can be very significant.

Mr. Bloomstran had an interesting (and relevant?) section a few short years ago (pages 51-60):

b8622c94-d42e-453d-bb67-3898a17a14c4.pdf (fmgsuite.com)

He makes the point that paying for book value (and holding for a while) will result in you earning the return on equity + or - the change that may occur in the price-to-book multiple.

 

This is a worthwhile read, especially when attempting to plumb the depths of current market sentiment. I love the way this guy writes and the way he invests.

 

"We didn’t own the FANG’s last year and as such, didn’t reap their 75% gain. We’re ok with that. Did the underlying value of those businesses compound by the same 75% rate? We don’t think so. We have never had a problem watching others get richer faster over short periods of time. For some that’s hard to do. If you owned the S&P 500 last year, those four FANG’s added 4% to the portion of your net worth in the S&P. Investors in the S&P 500 should know that for every $100 invested in the index, $7 are now a bet on the FANG’s. Berkshire gets less than $2. Facebook alone gets more than Berkshire. Would we be better off with a company like Facebook than with Berkshire Hathaway?" (page 11)

 

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I remember reading through a compendium of Berkshire Letters to Shareholders and it seems like WEB has always underpromised and over delivered.

 

image.thumb.png.b6a4e127e057c4824174153421de8cf6.png

(page 19)

 

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I know a lot of members here already understand this valuation method so I won't bore you with anything but the summary / preface to his exercise.

 

"Berkshire leaves the investor to determine fair value using the two data points they supply in most years. Our valuation hinges on Berkshire earning an underwriting profit averaging 5% going forward, on Berkshire paying taxes at a cash rate far below the nominal corporate rate for many years, and on the consolidated business commanding a premium valuation due to utilization of little debt, ownership of high-quality assets, extraordinarily low cost of capital, and conservative accounting, among other intangibles."

 

 

"While simply capitalizing a pre-tax earnings number and adding that value to the value of a portfolio of securities is easy and a great way to come up with a shorthand value for Berkshire, it isn’t sufficiently thorough. Our preferred way to value Berkshire, and the only way to really understand the nuances of the business, is to use a sum of the parts approach." (page 22)

 

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I just started reading this morning and will continue when I get back from classes. Even though I finally understand the all the reasons for Berkshires enormous advantage in terms of low cost financing, especially in times of high interest rates. I still have a nagging doubt that at some point it will become too unwieldy (and yes, I'm also imagining some kind of unlocked value). WEB has used a forest analogy to describe the business segments,

 

"He divides Berkshire’s holdings into five "groves": its non-insurance businesses that it controls; its collection of marketable equities; its controlling interest with other parties in several businesses; its cash and fixed-income instruments; and its insurance business."

 

https://www.morningstar.com/articles/915303/buffett-says-focus-on-the-forest-forget-the-trees

 

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Is there a a point at which the forest needs to be managed to avoid a huge fire,

and could it include a pruning that throws shareholders a bone (aren't mixed metaphors fun)?

 

I'll keep reading when I get back home and will likely have more idiotic ideas to annoy members with.

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