In today’s edition of Barron’s, Andrew Bary presents a bullish case for Berkshire Hathaway with a target price of $110,000 per share based on a valuation of 1.4 times Barron’s estimate of Berkshire’s book value per share in one year. Please click on this link for a preview of the Barron’s article which is only available in full to paid subscribers.
There are many different valuation models for Berkshire Hathaway and much controversy regarding which valuation approach is appropriate. At best, a valuation approach can only come up with a very rough estimate of intrinsic value. I came up with my own valuation approach which is heavily influenced by the earnings power of Berkshire’s insurance float. There are online calculators, such as the Berkshire Hathaway Intrinsivaluator that permit changing numerous variables to come up with a valuation.
How Meaningful is Berkshire’s Book Value?
Warren Buffett has encouraged shareholders to carefully examine book value per share and highlights the importance of the measure by providing a table showing growth in book value per share compared with the results of the S&P 500 over time. However, Mr. Buffett has clearly stated in shareholder letters that Berkshire Hathaway’s intrinsic value per share “far exceeds” book value per share (see, for example, Warren Buffett’s 1999 Chairman’s Letter.)
Why would intrinsic value “far exceed” book value? After all, isn’t book value per share a reflection of the value of Berkshire’s business interests including current values of marketable securities and reflecting historical retained earnings?
If Berkshire Hathaway consisted of only marketable securities that are marked to market for each accounting period, book value would indeed provide a relatively accurate reflection of intrinsic value and substantial premiums over book value would need to be justified based on the superior investment track record displayed over the years. However, Berkshire has a large and growing collection of operating companies that have shown steady growth over the years. While the retained earnings from these businesses have been reflected in Berkshire’s book value, the growth in the likely market value of subsidiaries has not.
What about goodwill reflected on the balance sheet? Doesn’t Berkshire have a large amount of goodwill and doesn’t this reflect the additional economic value of the operating subsidiaries? It is important to remember that accounting goodwill on the balance sheet reflects the excess amount paid for the business over tangible book value of the subsidiary at the time of purchase. Goodwill used to be subject to annual amortization which, for many years, further distorted the usefulness of book value as a valuation metric. While goodwill is no longer amortized, it is still tested for impairment annually. However, in no case is accounting goodwill adjusted upwards in cases where a subsidiaries economic moat has grown over time.
Mr. Bary’s article in Barron’s partially makes this point when he estimates the value of GEICO at $15 billion, a value far exceeding the purchase price of GEICO (for a full account of the GEICO purchase, I highly recommend reading the 1995 Chairman’s Letter). The example of GEICO is one of many. Another famous and obvious example involves See’s Candies, a subsidiary purchased in 1972 for $25 million which is now worth many multiples of the original purchase price.
Book Value Provides Directional Clues
Obviously, I am not suggesting that Berkshire’s accounting goodwill should be “marked up” as the economic goodwill of subsidiaries increase over time. This is absurd and would be subject to every kind of fraud, not at Berkshire but at many other companies, if codified into accounting conventions.
What I am suggesting is that book value per share is only useful in the sense that it provides directional clues regarding the change in intrinsic value of Berkshire over a period of time. To the extent that observers attempt to place a multiple on book value to arrive at intrinsic value, it is critical to understand that the multiple has to increase over time to compensate for the additional economic goodwill that would be reflected in the market value of operating subsidiaries if they were to be evaluated as stand alone businesses.
What is an Appropriate Multiple?
What is an appropriate price to book value multiple for Berkshire Hathaway today? I personally do not favor using this type of valuation metric, but I have trouble reconciling a 1.2 price to book value ratio based on an objective evaluation of the quality of the operating subsidiaries and I would note that I doubt that Mr. Buffett was referring to a 20% premium over book value when he stated that intrinsic value “far exceeds” book value.
Disclosure: The author owns shares of Berkshire Hathaway.