Book Value Oversimplifies Berkshire's Business

Ahead of Saturday's  Berkshire Hathaway (BRK.A) (BRK.B) annual meeting, we're taking a closer look at the best way to value the complex company. We believe that understanding the benefits and shortfalls of different methodologies can provide valuable insight into the ways in which different investors are approaching the firm's overall valuation. Part 1 of the series, exploring some of the shortfalls of using an earnings-based multiple approach, is available here. 

Book value serves as a reasonable proxy for intrinsic value but paints an oversimplified picture
While a book value multiple is undoubtedly an oversimplified picture of the relative price of a company, it is our preferred comparison metric for financials, and specifically for insurance companies. Furthermore, it tends to work well for holding companies such as Berkshire. While there are drawbacks to any simplified multiple based approach, financial companies mark most of their assets, and some of their liabilities, to prevailing market prices (or in cases where market prices are not available, to current best estimates), making book value a more meaningful metric. We'd also note that book value has been highlighted by Buffett as a useful tool for tracking changes in the company's intrinsic value, insomuch as changes in Berkshire's book value tend to track changes in the company's intrinsic value. In each of his annual letters to shareholders, Buffett starts with a chart that compares Berkshire's annual growth in book value per share with the annual appreciation of the S&P 500, allowing investors to assess the firm's relative performance. Additionally, Buffett's annual commentary about Berkshire's performance tends to begin from the lens of the firm's growth in book value.

Buffett believes that highlighting book value is important because it is an easily observable measure of Berkshire's performance. But, as he mentions in each annual report, book value is not a substitute for intrinsic value. The company is worth more than the simple book value per share reported each year. Berkshire owns a collection of above-average-quality businesses that should produce returns that routinely exceed their required cost of capital. By definition, a business that generates these types of returns should have an intrinsic value above its reported book value. Additionally, goodwill skews reported book value for many companies, including Berkshire, so a comparison should sometimes include a comparison with tangible book value. Finally, since Berkshire owns a substantial number of nonfinancial businesses, which report most assets on a cost basis, the reported book value of these businesses will consistently understate current market values of assets less liabilities.

As with the price/earnings multiple, determining a fair value estimate for Berkshire based solely on a multiple of book value is difficult because of the diversity of the firm's operations. Book value multiples differ a great deal for the firm's main business lines. Determining a blended multiple of book value to use for valuing Berkshire is even more troublesome, as assigning weightings to the firm's segments is problematic. In the firm's annual report a number of segments with very different business characteristics are lumped together, such as manufacturing, service, and retailing being included with its insurance operations and labeled as "other." It should also be noted that the finance and financial products segment has had a negative book value the last couple of years. If we were to make our best guess at the book value attached to each of Berkshire's main segments, based on its third-quarter book value per share of $111,718 per Class A share (or $74 per Class B share) and assuming a value of $0 for the finance and financial products segment, it might look something like this.

In this case, as opposed to the earnings-based multiple, the implied multiple is slightly above what we believe is fair for Berkshire based on our fair value estimate relative to the firm's book value. 

Applying the same weightings that we used for the earnings multiple, which was based on estimated earnings contributions for each of Berkshire's segments, leads us to a similar implied multiple for the firm overall.

This also leads to a higher valuation when compared with our fair value estimate relative to the firm's book value. 

The differential in both instances is likely due to improper weightings for the respective components. As we've previously detailed, insurance contributes 34% to our projected earnings but represents a larger component of the value of Berkshire. If insurance were to receive a higher weighting in either tables, the implied price/book multiple would move more toward what we think is fair for the company. Additionally, using peer comparisons for nonfinancial industries where book value is a much less relevant metric will occasionally cause problems.

While determining the appropriate multiple may be difficult, book value would seem to provide something of a floor for the value of the stock. Buffett clearly believes that Berkshire's intrinsic value is well above book value and that the appropriate multiple is fairly static.

At Berkshire, however, book value very roughly tracks business values. That's because the amount by which Berkshire's intrinsic value exceeds book value does not swing wildly from year to year, though it increases in most years. Over time, the divergence will likely become ever more substantial in absolute terms, remaining reasonably steady, however, on a percentage basis as both the numerator and denominator of the business-value/book-value equation increase. -- 2011 Berkshire Hathaway Annual Report

It should also be noted that Buffett has explicitly tied Berkshire's stock repurchase plan to a multiple of book value. In September 2011, the company's board of directors authorized a program to buy back both Class A and Class B shares at a price no higher than a 10% premium over Berkshire's then-current book value per share. In December of last year, the board raised this threshold to 120% of book value, coincident with the announcement of the purchase of 9,200 shares of stock from the estate of a longtime shareholder. Buffett has said he will only purchase shares of Berkshire when they are trading at a significant discount to its underlying intrinsic value, indicating that he believes the fair price to book multiple is considerably above that. We agree with this sentiment as our fair value estimate is equivalent to a multiple of approximately 160% of third quarter 2012 book value (and 220% of tangible book value).