Category Archives: Warren Buffett

A quick – and important – thought on P/E ratios

I am in the process of going back and carefully reading everything Buffett has to say about valuing assets.

If you have followed Buffett, you have probably read that he is not a big fan of P/E ratios. P/E ratios are a kind of shorthand. The problem is, that for all they may tell you about a business, there is a lot that they leave out, which brings me to my quick point.

When looking at a P/E ratio, train yourself to carefully look at how much capital was required to produce the “E” (earnings). This can tell you a lot about the quality of the earnings. A business producing $1 million of earnings utilizing $4 million in tangible assets is far different from a business producing $1 million of earnings that requires $9 million in tangible assets.

Both may have the same P/E. The P/E of the second business may even be lower, but that does not necessarily mean that it is cheaper.

Assume these are growth companies that you project to grow at 10% over the next ten years. From a GAAP perspective each business will generate about $17.5 million in “earnings” over the ensuing ten years, but there is a big difference in the economics of the two businesses. Assuming consistent returns on equity, the first business will require an additional $6 million of capital while the second business will require an additional $14 million.

All growth businesses are not created equal.

P/Es are a useful tool to make the first cut. But it is essential to go deeper and look at the amount of capital it took – and will take – to produce those earnings.

Berkshire Hathaway normalized after-tax look-through earnings at $18 billion

By my estimate, Berkshire Hathaway’s normal earning power after tax is approximately $18 billion. This puts the stock at an adjusted P/E ratio of 11x based on today’s share price.

To get there, I assume the following:

  • Redemption of GE, GS and Swiss Re preferred
  • Normalized but still low interest rates
  • Normalized dividend for Wells Fargo and U.S. Bancorp
  • 2012 dividend increase per consensus estimates
  • IBM full-year dividend
  • Full-year earnings for Lubrizol
  • A more normal housing environment

Following Buffett, I also include undistributed earnings from Berkshire’s large equity holdings.

No adjustment has been made for Berkshire’s large cash holdings which I expect will approximate $40 billion after Q1, 2012, assuming no major purchases. This equates to almost $25,000 per A share.

Here is my data.

 

 

 

 

 

 

 

 

 

 

I welcome your comments on these adjustments and your thoughts on Berkshire Hathaway’s valuation.

Berkshire Hathaway’s 2012 look-through earnings from stock investments look to be $4.5 billion

Buffett has long underscored that GAAP can sometimes obfuscate the economic performance of a business. To wit, Buffett introduced the notion of look-through earnings, which comprise both reported earnings AND any undistributed earnings of a company’s investees. (See Berkshire Hathaway’s Owner’s Manual for more details.) Buffett has underscored that including these earnings in a calculation of a business’s normal earnings power is highly useful in understanding where the business stands and in valuing the business. The tree still falls, even if nobody hears it.

In his 2011 letter to shareholders, Buffett made it a point to note that Berkshire’s share of the earnings of Coca-Cola, American Express, Wells Fargo and IBM – the “Big Four” – was $3.3 billion. Under GAAP, only $862 million of dividends were reported. The press mostly ignores or is ignorant of this reality in reporting Berkshire’s earnings. Therefore, many have a poor understanding of Berkshire’s true earnings power.

I made my own estimate of Berkshire’s 2012 look-through earnings from its equity investments. My estimate is $6.5 billion of which just under $2 billion will be paid to – and reported by – Berkshire as dividends. That leaves $4.5 billion that Berkshire will likely earn in 2012 that will not be reported. That is substantial. Buffett wrote in his 2010 letter that he estimated Berkshire’s normal after-tax earnings power to be $12 billion.

Berkshire’s total 2012 after-tax earnings – including look-through earnings – could be as high as $16.5 billion, or more.

One other detail should be mentioned. Years ago, when Buffett would provide a calculation of look-through earnings in his shareholder letters, he would deduct an amount equal to the additional taxes that Berkshire would have paid if all owner earnings were paid as dividends. In my judgment, that is overly conservative. Buffett is generally a very long-term holder of common stocks. The present value of the deferred taxes on the capital gains that will be derived from these retained earnings will be far less than the taxes due if these earnings were distributed as dividends in the years they were earned. Nevertheless, some adjustment should be made to any estimate of intrinsic value based on look-through earnings to account for Berkshire’s deferred tax liability.

Finally, my estimate is largely based on consensus 2012 earnings estimates for Berkshire common stock investments.

 

Warren Buffett: Why stocks beat gold and bonds

(CNN Money) In an adaptation from his upcoming shareholder letter, the Oracle of Omaha explains why equities almost always beat the alternatives over time.

At Berkshire Hathaway (BRKA) we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power — after taxes have been paid on nominal gains — in (continue reading)

IBM’s 2015 Roadmap and 2011 Business Review

IBM’s 2015 Roadmap and 2011 Business Review – source: IBM

IBM has a financial “roadmap” telling investors how profitable it intends to be in the next five years and how it will get there. By 2015 the firm wants its earnings per share almost to double, to “at least” $20. The roadmap also helps, according to Mark Loughridge, the chief financial officer, “to keep the same level of intensity” as during the near-death experience of the early 1990s. “If you ask executives about the roadmap 2015, they can tell you immediately how their plans are lined up to that longer-term goal,” he says. – The Economist

The human platform has an important drawback: it is expensive to maintain and to extend, says Carl Claunch of Gartner, a market-research firm. That also means, however, that it is costly for others to replicate or invade. And given the complexity of the world and how much of it is still to be digitised, IBM’s human platform looks unlikely to reach its limits soon. Perhaps not for another 100 years. – The Economist

 

Teledyne: Possible archetype for Berkshire Hathaway’s future?

Henry Singleton, Teledyne’s legendary chief executive, was a gifted capital allocator who created enormous shareholder value. Warren Buffett is a great admirer of Singleton and believes, “Singleton of Teledyne has the best operating and capital deployment record in American business.”

Singleton’s repurchases at Teledyne shed light, I believe, on what Buffett is doing at Berkshire. Financial journalists writing about Berkshire’s recently announced share repurchase policy – now actively underway – are often ill-informed and sometimes clueless.

The following article provides a good overview of Singleton’s record of capital allocation and will give you insight on how to think about and value Berkshire Hathaway’s stock, particularly as it regards the addition of share repurchases to Buffett’s capital allocation toolbox.

Teledyne and Henry Singleton a CS of a Great Capital Allocator

See previous blog post: Henry Singleton: A Master of Capital Allocation

Notes from Buffett meeting with students from Emory and UT Austin – February 15, 2008

Note: Students from Emory’s Goizueta Business School and McCombs School of Business at UT Austin were invited to come visit Mr. Buffett for a Q&A session. These notes were reproduced to the best of my ability as I heard and as I could recall them from a collection of mine and other students’ notes. There is no guarantee that this was exactly what was said, but the intent was to preserve the spirit of the message. Enjoy.

Emory:

With the popularity of “Fortune’s Formula” and the Kelly Criterion, there seems to be a lot of debate in the value community regarding diversification vs. concentration. I know where you side in that discussion, but was curious if you could tell us more about your process for position sizing or averaging down.

Buffett:

I have 2 views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.

If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice. “Lebron James” analogy. If you have Lebron James on your team, don’t take him out of the game just to make room for someone else. If you have a harem of 40 women, you never really get to know any of them well.

Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO. Later in 1998, LTCM was in trouble. With the spread between the on-the-run versus off-the-run 30 year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up.

Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal worth on a position. We’ve suffered quotational loss, 50% movements. That’s why you should never borrow money. We don’t want to get into situations where anyone can pull the rug out from under our feet.

In stocks, it’s the only place where when things go on sale, people get unhappy. If I like a business, then it makes sense to buy more at 20 than at 30. If McDonalds reduces the price of hamburgers, I think it’s great.

(continue reading)

Tom Gayner’s approach to valuing Berkshire Hathaway

The June 30, 2011 edition of Value Investor Insight includes an interview with Tom Gayner, the President and Chief Investment Officer of Markel Corporation. Gayner is a highly respected value investor.

In the interview, Gayner explains his approach to valuing Berkshire Hathaway. Per GuruFocus.com, Markel has a 7.15% equity weighting in BRK.B and a 6.39% equity weighting in BRK.A. Combined, Berkshire Hathaway is Markel’s largest equity position.

Gayner uses a sum-of-the-parts analysis and looks at the company in three parts: 1) the investment portfolio, 2) insurance operations, and 3) non-insurance operating businesses.

Gayner’s approach is of particular interest not only because he is a great value investor, but also because of his expertise in the insurance business.

For the investment portfolio, he considers a range of values. On the low end, he figures it will earn 3% up to a high-end of 10-12%.

For the insurance premiums, he considers a low case where Berskhire does not earn an underwriting profit, a middle case where its earns a 4 to 5% profit on insurance premiums, and a high case where it earns 8 to 9%.

Finally, he calculates his estimate of normalized earnings for the non-insurance operating businesses. He does this by looking at Berkshire’s cash flow over the past three years and then trying to estimate what this will look like over the next few years.

He then sums the earnings from the three parts and applies a 10x, 14x and 18x multiple. This gives him a range for his estimate of Berkshire’s intrinsic value.

I used Gayner’s general approach to value Berkshire and came up with a intrinsic value range for BRK.B of $55 to $208 with an average value of $128. Here is my data (click to enlarge).

 

 

 

 

 

 

 

I used Berkshire’s investment portfolio value from the 2011, first quarter 10-Q. To calculate insurance earnings, I used Berkshire’s 2010 insurance premiums. For normalized operating earnings, drawing upon Buffett’s own estimate of normalized earnings given in the 2010 shareholder letter, I used $9 billion as my estimate of normalized after-tax earnings for the non-insurance operating businesses.

I stress that this is my own estimate of intrinsic value based on Gayner’s approach as put forth in the interview. I am not privy to Gayner’s input data, particularly his estimate of Berkshire’s future cash flows for the operating businesses.

In the interview in Value Investor Insight, Gayner stated that based on his estimates, “At even the low ends of the range, the resulting value is significantly higher than today’s share price.”

The absolute low of my range, $55, is actually lower than Berkshire current share price of around $76. However, Berkshire is certainly selling near the bottom of my range of intrinsic value.

In closing, Gayner made an interesting observation that, although Berkshire is widely known, many don’t get around to actually analyzing the company. There are Buffett devotees who are “all in” because of Buffett, and those who dismiss the stock because they’ve already made up their minds without looking at the facts.

Perhaps that creates opportunity for those of us willing to do a little math.

Value Investors Club write-up values Berkshire Hathaway B shares at $125

A member of the Value Investors Club named Den1200 has valued Berkshire Hathaway B shares at $125.05 per share in his March 28, 2011 write-up of the company. I think his approach and logic are sound. (You can sign up for guest access to the Value Investors Club to see the actual write-up.)

The $125 valuation is over 60% higher than Berkshire’s current trading price of about $77.

Let’s walk through Den1200’s logic.

He starts with the fact that in Warren Buffett’s 2010 letter to shareholders, Buffett estimates Berskhire’s normalized pre-tax earnings power to be $17 billion. This figure does not include insurance cat losses as Berkshire has shown the ability to operate at a combined ratio of less than 100%. (In my judgment, there is reason to believe that Berkshire’s insurance operations will be net profitable over the long-term which would further add to Berkshire’s value.)

Den1200 then proceeds to use a two-track approach to value Berskhire which values the business as the sum of its investments – which includes equities, fixed income, cash, and cash equivalents – and capitalized non-insurance operating earnings. This is the general approach used by Buffett in multiple shareholder letters.

Non-Insurance Operating Earnings

After subtracting all Berkshire’s investment income, Den1200 calculates that the non-insurance operating businesses earn normalized earnings of $12.07 billion pre-tax. If you include Lubrizol’s earnings, Berkshire pre-tax operating earnings grow to $13.04 billion. That equates to $9.13 billion after tax, given Berkshire’s 30% tax rate. Lubrizol is being acquired by Berkshire and its earnings were not included in Buffett’s normalized earnings estimate.

Den1200 then assumes that Berkshire’s earning can conservatively grow at 5% and will be $9.88 billion by December 31, 2012. That equates to $4.00 per B share or $60 of intrinsic value if valued at 15 times earnings.

Buffett has traditionally hinted at a higher multiple when valuing Berkshire. Given the high-quality nature of Berkshire’s operating businesses, a market multiple seams reasonable.

Investment per Share

In addition to the non-insurance operating businesses, Berkshire has $155.86 billion in investments. Den1200 makes several adjustments to this figure. He first subtracts $5.56 billion to account for deferred taxes on the equity holdings. He then subtracts $9.7 billion to account for the cash used in the Lubrizol purchase and adds $1.06 billion for pre-payment penalties from Goldman Sachs, GE and Swiss Re related to redemptions.

These adjustments yield $141.65 billion in investments or $57.40 per B share.

Finally, he notes that this figure probably understates the intrinsic value of Berkshire’s large equity holdings as several may be undervalued, namely AXP, JNJ, KFT, Munich Re, POSCO, WMT, USB and notably WFC.

Berkshire’s Intrinsic Value

Den1200 then estimates that Berkshire will earn $18.90 billion or $7.65 per B share between the time of the write-up (March 28, 2011) and December 31, 2012.

Adding it all together, Deb1200 calculates that the intrinsic value of Berskhire will be $125.05 in December, 2012 ($60.00 for its capitalized operating earnings + $57.40 for its investments + $7.65 future earnings through Dec 2012). That figure is 60% higher than Berkshire’s current price.

Closing Thoughts

Berskhire’s derivative book has been a source of concern for several years now as investors have seen several companies blow up as a result of poor derivative bets. Den1200 argues that this level of risk is not likely present in Berkshire’s portfolio and calculates that even a major hit on those contracts would only equate to a relatively modest reduction in Berkshire’s intrinsic value.

Regarding Buffett’s eventual departure, Den1200 suggests that the negative case may already be baked into the stock; it’s hardly a secret that Buffett is 80. At the current price, if Buffett lives several more years – or even longer – his capital allocation decisions are available now as a free option.

Finally, Berkshire operates in a highly decentralized manner with highly skilled division CEO’s. Couple that with Berkshire’s strong culture and a talented board with plenty of skin in the game and it is not a stretch to conclude that Buffett’s departure will have little effect on day-to-day operations.

Long-term it is unreasonable to expect to find a capital allocator as good as Buffett. There was only one Michael Jordon. That doesn’t mean there are not very capable, talented players in the NBA today.

Charlie Munger on Google’s moat – it’s huge … probably widest he’s ever seen

Buffett has famously said that one useful way to think about a business’s moat – its durable competitive advantage – is to imagine that you had unlimited resources to attack it.  If you still could not topple it, you would have found a business with a solid moat.

In Google’s case, this isn’t a hypothetical.  Microsoft has spent billions of dollars in a determined effort to put a dent in Google’s moat.  So far, all they have to show for it is heavy losses and only modest market share.  It is believed that a large part of Bing’s market share has come at the expense of search engines other than Google. Microsoft was recently embarrassed when Google discovered that it was copying Google’s search results.

Charlie Munger had this to say about Google’s moat. “Google has a huge new moat. In fact I’ve probably never seen such a wide moat.”

Why?

It’s useful to think about Google’s moat the way you would think about the moat of a dominant city newspaper in the pre-Internet era.

NEWSPAPERS – THE READER’S PERSPECTIVE

For readers, the newspaper was the only game in town for keeping up with local news and an essential tool for buying a car, getting a job, learning about retail sales events, and an almost limitless number of niche activities.  Reading the paper was also quintessentially habit forming: pleasurable, repeated daily and low cost.

If you use the Internet, Google is a basic essential tool.  Its value lies in letting you navigate the Internet in a rational fashion, whether you’re looking to buy a new camera or need to know the capital of Uzbekistan.  This value grows as more information is placed on line – something that is happening at a dizzying pace – and as Google’s search algorithm improves.  Google is maniacally focused on improving its search engine and it benefits from having by far the largest number of searches to analyze and learn from.

It tells you something about a company when the company’s name becomes a verb that is synonymous with the underlying function it performs. Could you “xerox” that for me?  Google has this kind of mind share.

If you’re Bing, you can’t attack by lowering the price to customers. Google is free. At one point, Bing even tried paying people to search. There is no easy lever to disrupt the habit of going to Google each day to navigate the web.

NEWSPAPERS – THE ADVERTISER’S PERSPECTIVE

If you were an advertiser – auto dealer, employer, department store, furniture store, pretty much any local business – you needed to advertise in the newspaper because you had to be in front of your customers and that was the only cost effective way to do it.  The newspaper set the rate and you paid it.  Period.

Google is a must-have outlet for advertisers given its 65% share of U.S. search.  Its share is much higher in many international markets.  Advertisers not only pay for advertising but also work hard to optimize their sites so they show up at the top of searches on important key words.  A recent tweak in Google’s search algorithm showed the lengths that companies will go to rise in the search rankings.  A company can see it’s sales materially reduced if it falls in the rankings.

Google’s advertising is superior to that of traditional media because it is targeted and the results can be quantified.  More value means happier advertisers.  That rates are set by auction helps mitigate accusations of monopolistic price gauging which were frequently heard in the “old days” from newspaper advertisers.

A dominant daily newspaper’s growth was constrained by the development of the local economy.  Google is not constrained by local geography and is riding two huge secular waves: the transfer of advertising dollars to the Internet and the ever increasing adoption and usage of the Internet.

Regulatory risks swirl around Google but the threat to its core search business seems remote. Because Google’s business is based on technology, there is a some risk of disruption from creative destruction.  However, Google is determined to stay ahead in search and it has plenty of cash to purchase start-ups with a better idea.

Recent price: 524.20

Cash per share: 113.00

Cash adjusted price: 411.20

2012 consensus EPS estimate: 39.91

2012 cash adjusted earnings yield: 9.7%