Berkshire Hathaway Inc.
NYSE: BRKA
Recommendation: Buy
Current Price: $123,970
Target Price: $145,000
Analyst Information:
Investment Thesis
Berkshire Hathaway is a holding company headquartered
in Omaha, Nebraska. Berkshire’s subsidiaries engage in
various lines of business including property and casualty
insurance and reinsurance, utilities and energy, finance,
manufacturing, services, and retailing. Berkshire has
consistently demonstrated an ability to generate exceptional
returns on capital. In addition, the company has thrived in
prior periods of economic turmoil and has created tremendous
value for its shareholders as a result. Berkshire’s constant
focus on prudent capital allocation and acquiring businesses
that possess sustainable competitive advantages will allow
the company to prosper for decades to come. When shares of
this type of company are trading at a discount to intrinsic
value, as Berkshire’s shares currently are, it is a tremendous
opportunity for the long-term investor to purchase a stake in
a company that will generate a consistent and reasonable return
for decades to come.
Berkshire Hathaway’s strengths include:
• $35.6 billion in cash that will allow the company to
capitalize on opportunities presented by the current
economic climate.
• Minimal leverage, a AAA credit rating, and consistent
generation of sizeable free cash flow.
• Zero “Buffett premium” built into the current price, and
potentially even a “Buffett discount.”
• The opportunity to capitalize on the eventual
turnarounds of the financial and housing sectors without
assuming the risks associated with pure-play companies
in these sectors.
Earnings Per Share
In dollars per share
$9,000
$8,548
$8,000
$7,144
$7,000
$6,000
$5,538
$5,309
$4,753
$4,000
$3,000
$2,795
$2,000
$1,000
$0
2002
2003
Contact: 614.599.6017
E-mail: Palmer.298@osu.edu
Updated: May 26, 2008
Fund:
OSU SIM (BUS FIN 824)
Manager: Royce West, CFA
Stock Information:
Summary
$5,000
Analyst: Nate Palmer
Fisher College of Business
The Ohio State University
Columbus, Ohio
2004
2005
2006
2007
Sector:
Industry:
Financial
Insurance
Market Cap:
$192.004 billion
Shares Outstanding: 1.5 million
52 Week High:
52 Week Low:
YTD Return:
Beta:
$151,650
$107,200
-12.45%
0.30
Table of Contents1
Investment Thesis……………………………………………………………………………………….…1
Summary…………………………………………………………………………………………………...1
Company Overview………………………………………………………………………………………..3
Macroeconomic Analysis and Outlook…………………………………………………………………....4
Financial Sector Analysis and Outlook……………………………………………………………………5
Financial Sector Valuation………………………………………………………………………………...6
Berkshire Relative to Financial Sector…………………………………………………………………….7
Berkshire Absolute Valuation……………………………………………………………………………..8
How Buffett Values Berkshire…………………………………………………………………………….8
Investment Portfolio……………………………………………………………………………………….9
Operating Businesses……………………………………………………………………………………..10
Comparative Analysis: Berkshire Relative to Conglomerates…………………………………………....12
Comparative Analysis: Berkshire Relative to Insurers………………………………………………...…13
Discounted Cash Flow Analysis………………………………………………………………………….14
Income Statement Projection……………………………………………………………………………..14
Discounted Cash Flow Model………………………………………………………………………….....14
Risks and Concerns……………………………………………………………………………………….15
Key Manager Risk .. …………………………………………………………………………….………..15
Insurance Industry……………………………………………………………………………...…………16
Derivatives………………………………………………………………………………………....…...…17
Conclusions………………………………………………………………………………………………..17
Appendix 1: Berkshire Hathaway Financial Statements from Company10-K…………………….……...19
Appendix 2: Berkshire Hathaway Income Statement Forecast and Discounted Cash Flow Model………22
1
Data in all absolute and relative valuation tables was provided by StockVal
2
Company Overview2
Headquartered in Omaha, Nebraska, Berkshire Hathaway Inc. is a holding company owning
subsidiaries that engage in a number of diverse business activities including property and casualty
insurance and reinsurance, utilities and energy, finance, manufacturing, services, and retailing. Included
in the group of subsidiaries that underwrite property and casualty insurance and reinsurance is GEICO,
one of the four largest auto insurers in the United States. This group also includes two of the largest
reinsurers in the world, General Re and the Berkshire Hathaway Reinsurance Group. Other subsidiaries
that underwrite property and casualty insurance include National Indemnity Company, Medical Protective
Company, Applied Underwriters, U.S. Liability Insurance Company, Central States Indemnity Company,
Kansas Bankers Surety, Cypress Insurance Company, BoatU.S., and several other subsidiaries referred to
as the “Homestate Companies.”
MidAmerican Energy Holdings Company (“MidAmerican”) is an international energy holding
company owning a wide variety of operating companies engaged in the generation, transmission and
distribution of energy. Among MidAmerican’s operating energy companies are Northern Electric,
Yorkshire Electricity, MidAmerican Energy Company, Pacific Power, Rocky Mountain Power, Kern
River Gas Transmission Company, and Northern Natural Gas. In addition, MidAmerican owns
HomeServices of America, a real estate brokerage firm. Berkshire’s finance and financial products
businesses primarily engage in proprietary investing strategies (BH Finance), commercial and consumer
lending (Berkshire Hathaway Credit Corporation and Clayton Homes), and transportation equipment and
furniture leasing (XTRA and CORT). Shaw Industries is the world’s largest manufacturer of tufted
broadloom carpet. McLane Company is a wholesale distributor of groceries and nonfood items to
convenience stores, wholesale clubs, mass merchandisers, quick service restaurants and others.
Numerous business activities are conducted through Berkshire’s other manufacturing, service,
and retailing subsidiaries. Benjamin Moore is a formulator, manufacturer, and retailer of architectural
and industrial coatings. Johns Manville is a leading manufacturer of insulation and building products.
Acme Building Brands is a manufacturer of face brick and concrete masonry products. MiTek Inc.
produces steel connector products and engineering software for the building components market. Fruit of
the Loom, Russell, Vanity Fair, Garan, Fechheimer, H.H. Brown Shoe Group, and Justin Brands
manufacture, license, and distribute apparel and footwear under a variety of brand names. FlightSafety
International provides training to aircraft and ship operators. NetJets provides fractional ownership
programs for general aviation aircrafts. Nebraska Furniture Mart, R.C. Willey Home Furnishings, Star
Furniture, and Jordan’s Furniture are retailers of home furnishings. Borsheims, Helzberg Diamond
Shops, and Ben Bridge Jeweler are retailers of fine jewelry.
2
Adapted from Berkshire Hathaway 2007 10-K
3
In addition, other manufacturing, service and retail businesses include: Buffalo News, a publisher
of a daily and Sunday newspaper; See’s Candies, a manufacturer and seller of boxed chocolates and other
confectionery products; Scott Fetzer, a diversified manufacturer and distributor of commercial and
industrial products, the principal products of which are sold under the Kirby and Campbell Hausfeld
brand names; Albecca, a designer, manufacturer, and distributor of high-quality picture framing products;
CTB International, a manufacturer of equipment for the livestock and agricultural industries; International
Dairy Queen, a licensor and service provider to approximately 6,000 stores that offer prepared dairy treats
and food; The Pampered Chef, the premier direct seller of kitchen tools in the U.S.; Forest River, a
leading manufacturer of leisure vehicles in the U.S.; Business Wire, the leading global distributor of
corporate news, multimedia, and regulatory filings; Iscar Metalworking Companies, an industry leader in
the metal cutting tools business; TTI, Inc., a leading distributor of electronic components, and Richline
Group, a leading jewelry manufacturer.
Operating decisions for the various Berkshire businesses are made by managers of the business
units. Investment decisions and all other capital allocation decisions are made for Berkshire and its
subsidiaries by Warren E. Buffett, in consultation with Charles T. Munger. Mr. Buffett is Chairman and
Mr. Munger is Vice Chairman of Berkshire’s Board of Directors.
Macroeconomic Analysis and Outlook
The macroeconomic outlook for 2008 has weakened significantly in the past 6 months as the
effects of the global credit crunch and current housing crisis are being felt throughout the entire domestic
and global economy. Although a recession seems eminent, consensus seems to be that the recession will
be relatively short and shallow in nature. I disagree with the consensus and believe that the recession will
be both longer and more severe than consensus estimates. Both George Soros and Warren Buffett, two of
the greatest macroeconomic minds of their generation, are on record saying that they believe the recession
will be longer and deeper than most people are currently forecasting. Soros has even called this “the
worst economic crisis in 75 years.”3 I agree with these individuals that the collapse of housing prices in
combination with the large-scale contraction in lending will prove detrimental to the overall economy in
2008. I currently forecast single digit negative GDP growth in 2008. Because this outlook is
significantly below the consensus, if it materializes, there could be sizeable declines in stock prices as
investors adjust their expectations.
Macroeconomic Impact on Berkshire Hathaway
Because Berkshire Hathaway’s operating businesses and investment portfolio are diversified over
numerous industries and lines of business, the risk of a downturn in any single sector of the economy
3
Schurenberg, Eric. "Big-Picture Guy." Money June 2008: 114.
4
having a major impact on Berkshire is minimal. Due to its size and diversification, Berkshire is a
defensive play for most investors. Nonetheless, Berkshire has significant exposure to both the financial
and housing sectors. With 2007 earnings per share of $8,548, a 19.7% increase from 2006 EPS, it would
seem that Berkshire was running on all cylinders. However, as detailed in the Company Overview above,
the performance of several of Berkshire’s operating businesses is directly tied to the housing sector.
Acme Brick Co., Clayton Homes, Jordan’s Furniture, RC Wiley Home Furnishings, Shaw Industries, and
Star Furniture were all adversely affected in 2007 by the downturn in the housing sector. In addition,
Berkshire’s investment portfolio was hurt by significant exposure to financials as well as slight exposure
to the housing sector. The market value of investments in American Express, Moody’s Corporation, U.S.
Bancorp, and Wells Fargo declined notably as a result of the current credit situation. In addition, the
market value of Berkshire’s investment in USG, which manufactures and distributes building materials
and gypsum wallboard, declined significantly due to the lack of new construction in the homebuilding
industry. So although Berkshire posted strong earnings figures in 2007, this was despite the struggles of
its businesses and investments related to the housing and financial sectors. When economic conditions
improve, it is reasonable to assume that these businesses will be able to revert to normalized earnings, and
Berkshire’s bottom line will benefit further. Thus, although its sector diversification prevented Berkshire
from being as adversely affected by the current housing and credit situation as many of its competitors,
the company will still realize substantial benefit from the eventual turnaround in the housing and financial
sectors.
Financial Sector Analysis and Outlook
The financial sector is in the mature phase of the life cycle, but will continue to grow with the
overall economy since financial institutions serve as the major source of capital for economic expansion.
As the figure to the right4 illustrates, financials perform best late in bear markets and early in bull
markets. Thus, there is significant upside in financials when the current economic downturn begins to
subside, but in order to profit in the sector, investors
may need to be patient.
The financial sector was severely battered in
2007, and the carnage has continued thus far in
2008. While the sector as a whole has rebounded
slightly from its trough earlier in 2008, significant
pessimism remains. Although bargains do exist in
4
Stovall, Sam. The S&P Guide to Sector Investing.
New York: McGraw Hill, 1995.
5
Financial Sector Returns
the sector, it is also full of value traps. Recent capital infusions at
Washington Mutual, National City, Wachovia, and others have illustrated
how quickly shareholders can be diluted when financial institutions are
desperate to raise capital. In addition, the near-collapse of Bear Stearns
illustrated the inherent danger of highly leveraged financial institutions.
YTD
2007
2006
2005
Return
-16.05%
-20.82%
17.02%
5.12%
Difference
Relative to
S&P500
-9.76%
-24.35%
+3.41%
+2.12%
Further write-downs at many financial institutions may pose the risk of insolvency, which carries with it
the potential that existing equity holders could be completely wiped out.
Due to the risk of financials in the current economic environment, this sector as a whole is not for
the short-term investor or overly risk averse investor. However, careful selection of financial institutions
that were fearful while their peers were greedy and are now poised to be greedy while others are fearful,
could produce significant returns for the long-term oriented investor. Nonetheless, investors in financials
must realize that if economic conditions continue to worsen, things could get worse in the financial sector
before they get better.
Financial Sector Valuation
Financial Sector Valuation - Absolute - 10 years
Forward PE
Trailing PE
Price to EBITDA
Price to Sales
Price to Book
Price to Cash Flow
PEG Ratio
Return on Equity
High
24.40
21.60
4.50
29.50
3.40
14.20
1.40
19.20
Low
10.30
10.50
2.20
13.76
1.30
9.20
0.80
8.30
Mean
14.20
14.30
3.50
20.09
2.10
11.80
1.10
15.90
Current
13.20
15.90
2.50
18.92
1.30
12.60
1.20
8.30
Percent From
Mean
-7.0%
11.2%
-28.6%
-5.8%
-38.1%
6.8%
9.1%
-47.8%
Financial Sector Valuation - Relative to S&P 500 - 10 years
Percent From
Mean
High
Low
Mean
Current
Forward PE
1.35
0.52
0.71
0.91
28.2%
Trailing PE
1.05
0.49
0.71
0.96
35.2%
Price to EBITDA
0.64
0.38
0.51
0.40
-21.6%
Price to Sales
19.07
6.67
11.64
14.58
25.3%
Price to Book
0.77
0.48
0.69
0.50
-27.5%
Price to Cash Flow
1.28
0.79
1.01
1.17
15.8%
PEG Ratio
1.09
0.68
0.85
1.01
18.8%
Return on Equity
1.11
0.52
0.93
0.52
-44.1%
On an absolute basis, despite appearing to be fairly valued in comparison to the multiples at
which the sector has traded over the past 10 years, financials may in fact be undervalued. Because the
earnings of financial institutions are currently at cyclical lows due to the recent write-downs in the sector,
6
as earnings revert to the mean, the current multiples will likely appear cheap. The challenge for investors
is determining how long it will take for earnings in the financial sector to revert to the mean. The three
metrics that stand out in the absolute valuation are the price to EBITDA multiple, the price to book
multiple, and return on equity. All three of these metrics are impacted by the recent write-downs that
financial institutions have been forced to take. Because of the applicable accounting principles for
financial institutions, EBITDA excludes write-downs at most of these institutions. Therefore, current
price to EBITDA multiples are artificially low for institutions that have been burdened by major writedowns in recent quarters since EBITDA excludes these write-downs (and thus EBITDA is artificially
high). The seemingly low price to book value multiple is also a function of write-downs in the financial
sector. In anticipation of future write-downs, investors have discounted book value and are willing to pay
a much lower multiple to stated book values because of the high probability that many financial
institutions will be forced to take additional write-downs. Finally, the low return on equity is a direct
result of write-downs as well. Write-downs have decimated net income for financial institutions, and
therefore return on equity is unusually low. Over the long-term, it is reasonable to expect net income and
return on equity to revert to the mean in the financial sector as economic conditions improve and these
institutions are able to move past the effects of the sub-prime lending crisis. Because of the unusually
low current net income figures at financial institutions as a result of write-downs, the financial sector will
likely prove to be relatively cheap despite current multiples seeming to indicate that it is fairly valued.
Relative to the S&P 500, financials appear to be expensive on the basis of price to forward and
trailing earnings, but this is the result of write-downs as discussed previously. Because many of these
write-downs are non-recurring items, financials again appear cheap on the basis of price to EBITDA. The
price to book ratio also indicates that financials may be cheap, but this is largely the result of investor
anticipation of future write-downs. Although the current turmoil in the financial sector makes it difficult
to definitively determine whether the sector is cheap relative to the S&P 500, it is apparent that there is
significantly more uncertainty in the financial sector than in the overall market. Investors will have to
determine whether the discounts in the sector are sufficient compensation for bearing the additional risk
associated with financials.
Berkshire Relative to Financial Sector
BRKA Relative to Financial Sector - 10 years
Percent From
Mean
High
Low
Mean
Current
Forward PE
6.24
0.75
1.98
1.64
-17.2%
Trailing PE
4.76
1.13
2.09
1.29
-38.3%
Price to EBITDA
4.12
1.69
2.51
3.89
55.0%
Price to Sales
0.47
0.05
0.13
0.09
-30.8%
Price to Book
1.32
0.41
0.76
1.21
59.2%
Price to Cash Flow
1.95
1.17
1.45
1.29
-11.0%
PEG Ratio
99.90
1.05
1.45
1.17
-19.3%
Return on Equity
0.95
0.11
0.38
0.95
150.0%
7
Although multiples in the financial sector are distorted by recent and anticipated future writedowns as addressed previously, Berkshire appears cheap relative to financials based upon several metrics.
Forward earnings, trailing earnings, sales, cash flow, and the PEG ratio all indicate that Berkshire is cheap
relative to the financial sector. However, Berkshire appears expensive relative to the sector on the basis
of EBITDA and book value. Despite the lack of a consensus valuation for Berkshire relative to the
financial sector, because a majority of the fundamental multiples indicate that it is cheap relative to the
sector, it is reasonable to conclude that Berkshire is currently trading at a discount to its historical
multiples relative to the financial sector.
Berkshire Absolute Valuation
Forward PE
Trailing PE
Price to EBITDA
Price to Sales
Price to Book
Price to Cash Flow
High
99.9
82.5
10.6
8.5
2.9
20.0
BRKA Fundamental Multiple-Based Valuation - 10 years
Current
Normalized Metric Per
Multiple
Share
Low
Mean
Current
13.0
26.5
21.7
26
5,713
15.6
27.7
20.5
27
6,047
7.3
9.0
9.9
9
12,522
1.5
2.4
1.8
2.3
69,646
1.1
1.6
1.6
1.6
77,481
13.8
16.7
16.3
16.7
7,606
Implied Target Price
$148,535.48
$163,277.56
$112,700.00
$160,185.96
$123,970.00
$127,012.21
Absolute valuation of Berkshire Hathaway produces a relatively wide range of target prices.
While the forward PE ratio, trailing PE ratio, and the price to sales ratio indicate that Berkshire is
significantly undervalued, the price to book and price to cash flow ratios indicate that it is fairly valued.
Finally, the price to EBITDA ratio indicates that Berkshire is overvalued at its current price. Overall, it
appears that Berkshire may be undervalued on an absolute basis, and at worst, it is fairly valued. The
forward PE multiple, trailing PE multiple, and price to sales ratios all produce target prices that are above
my target price of $145,000. However, since none of the historical multiple-based valuation methods
provide a definitive valuation for Berkshire, it is necessary to examine other valuation methods to
establish a framework within which the target price of $145,000 can be evaluated.
How Buffett Values Berkshire
Berkshire’s 1997 10-K provides the following guidance on valuation: “In our last two annual
reports, we furnished you a table that Charlie and I believe is central to estimating Berkshire’s intrinsic
value…In effect, the columns show what Berkshire would look like were it split into two parts, with one
entity holding our investments and the other operating all of our businesses and bearing all corporate
costs.” Berkshire’s investments per share and pre-tax earnings per share excluding all investment income
are displayed to the right. Since 1993,
Year
2007
Investments Per Share
$90,343
8
Pre-Tax Earnings Per Share
Excluding All Investment Income
$4,093
applying a 13 multiple to the pre-tax earnings per share generated by the operating businesses and adding
this figure to investments per share has provided a reliable approximation of Berkshire’s intrinsic value.
This valuation method provides an intrinsic value of $143,552 per share based on figures provided in the
2007 10-K. This target price is 15.6% above the May 23, 2008 closing price, and is very close to my
target price of $145,000. While this would seem to imply a reasonable margin of safety at the current
market price, examination of Berkshire’s investment portfolio and its collection of operating businesses is
necessary to affirm that this valuation method does provide a reasonable proxy for intrinsic value.
Investment Portfolio
Since 1964, Berkshire has constantly sought to build and grow an equity portfolio of publiclytraded businesses that possess “wide moats” and are selling at a discount to intrinsic value at the time of
purchase. A business with a “wide moat” is one that possesses a sustainable competitive advantage that
will endure both economic and
societal changes. This competitive
advantage allows these businesses to
generate abnormally high returns on
capital, and thus should consistently
provide reasonable returns to
Year
1965
1979
1993
2007
Investments per Share Over Time - 1965 - 2007
Compound Annual
Gain in Per Share
Investments
Per Share Investments
Years
$4
$577
1965 - 1979
42.8%
$13,961
1979 - 1993
25.6
$90,343
1993 - 2007
14.3%
shareholders over the long-term if the shares can be purchased at a reasonable price. However, by
purchasing shares in these businesses when they are selling at a discount to intrinsic value, Berkshire has
been able to generate exceptionally high returns in its equity portfolio. Because emphasis is placed on the
long-term sustainability of the business’ competitive advantage, Berkshire often intends to hold these
shares forever, leading to
Berkshire Hathaway Investment Portfolio - 12/31/2007
the mantra that the
company’s “favorite time
to sell is never.” The free
cash flow provided by
Berkshire’s operating
businesses, coupled with
the float provided by its
insurance businesses, has
served as a constant
source of capital for new
equity investments in the
investment portfolio. The
Shares
151,610,700
35,563,200
60,828,818
200,000,000
17,508,700
64,271,948
124,393,800
48,000,000
3,486,006
101,472,000
17,170,953
227,307,000
75,176,026
17,072,192
19,944,300
1,727,765
303,407,068
17,242,000
Percentage of
Cost
Company Owned (in millions)
Company
American Express Company
13.10%
$1,287
Anheuser-Busch Companies, Inc.
4.80%
$1,718
Burlington Northern Santa Fe
17.50%
$4,731
The Coca-Cola Company
8.60%
$1,299
Conoco Phillips
1.10%
$1,039
Johnson & Johnson
2.20%
$3,943
Kraft Foods Inc.
8.10%
$4,152
Moody's Corporation
19.10%
$499
POSCO
4.50%
$572
The Procter & Gamble Company
3.30%
$1,030
Sanofi-Aventis
1.30%
$1,466
Tesco plc
2.90%
$1,326
U.S. Bancorp
4.40%
$2,417
USG Corp
17.20%
$536
Wal-Mart Stores, Inc.
0.50%
$942
The Washington Post Company
18.20%
$11
Wells Fargo & Company
9.20%
$6,677
White Mountains Insurance Group Ltd.
16.30%
$369
Others
$5,238
Total Common Stocks
$39,252
9
Market Value as
of 12/31/07 (in
millions)
$7,887
$1,861
$5,063
$12,274
$1,546
$4,287
$4,059
$1,714
$2,136
$7,450
$1,575
$2,156
$2,386
$611
$948
1,367
$9,160
$886
$7,633
$74,999
current market value of the common stock held in Berkshire’s investment portfolio is $74.999 billion.
Although the size of Berkshire has limited the company’s investment universe to primarily other
large-capitalization companies, Berkshire has consistently exhibited the ability to generate above-market
returns in the portfolio. Over the period from 1993 to 2007, the portfolio grew at a rate of 14.3% per
year, which surpassed the return of every major index over that period. So while Berkshire’s current size
will almost certainly prevent it from ever repeating the 42.8% annualized growth of the investment
portfolio that was generated from 1965 to 1979, it is not unreasonable to expect at least market returns
from the portfolio, and recent history would seem to indicate that market outperformance is a very
realistic expectation. The notion that Berkshire is too big to grow its investment portfolio at an abovemarket rate certainly has not held true over the past 15 years. At a minimum, the portfolio will almost
assuredly generate steady returns over the long-term regardless of economic conditions.
Operating Businesses
As Berkshire has grown, so has the importance of its collection of operating businesses. While
Berkshire’s size now prevents it from taking meaningful partial stakes in small-capitalization and most
mid-capitalization companies, it can acquire entire small and mid-size businesses, in addition to large
businesses. In acquiring entire
Operating Businesses Over Time - 1965 - 2007
businesses, Berkshire seeks the
same type of “moat” that it seeks
in its investment portfolio.
Although it is much more difficult
to acquire an entire business at a
Year
1965
1979
1993
2007
Per Share Pre-Tax
Earnings
$4
$18
$212
$4,093
Years
Compound Annual
Gain in Per Share
Pre-Tax Earnings
1965 - 1979
1979 - 1993
1993 - 2007
11.1%
19.1%
23.5%
deep-discount price than it is to acquire a portion of a business at this type of price, Berkshire has
consistently demonstrated the ability to identify businesses that possess sustainable competitive
advantages and has been able to acquire these businesses at a reasonable price.
For many Berkshire subsidiaries, the sustainable competitive advantage amounts to a combination
of a brand name that
Distribution of 2007 Non-Insurance Earnings
promises quality,
coupled with a price
that is the best for that
level of quality.
Other Services
14%
Financial
15%
McLane
3%
Nebraska Furniture
Mart serves as a prime
example of how it and
Financial
Other
Manufacturing
31%
McLane
MidAm erican
Shaw
Retail
Retail
4%
many other Berkshire
10
Shaw
6%
MidAm erican
27%
Other Manufacturing
Other Services
Berkshire Hathaway Operating
Businesses
subsidiaries are able to prosper in both favorable and unfavorable
economic conditions. During favorable economic periods, their customer
base has a sizeable amount of discretionary income and purchases luxury
items and high-end electronics for their homes. Price is not as much of a
concern for many customers during these periods, and high-end and high
margin products are quite popular. During unfavorable economic periods,
price becomes more of a concern, and customers are attracted to Nebraska
Furniture Mart for the value lines of furniture carried in the store. In
addition to the usual customer base, the stores thrive during economic
downturns by attracting customers from other furniture and electronic
chains that cannot compete with the prices offered on Nebraska Furniture
Mart’s value lines. The ability to appeal to customers in all economic
conditions allowed Nebraska Furniture Mart to have a record year in 2007
while many of its competitors struggled mightily. Management has
indicated that both sales and margins have remained strong at the chain
thus far in 2008.
Prudent capital allocation among the operating businesses has
served as another source of competitive advantage for Berkshire’s
operating businesses. Each of the businesses retains cash needed to operate
and expand the business, but excess capital is returned to Omaha to be
strategically allocated by Buffett and Munger. This emphasis on putting
excess capital to use in the most effective manner has been one significant
factor in Berkshire’s ability to continue to generate high returns on capital
despite its enormous size.
A final source of competitive advantage for Berkshire with respect
to its operating businesses is that Berkshire is the buyer of choice for
certain privately held businesses. It is well documented that Berkshire
does not become involved in bidding wars when acquiring an operating
business because of the company’s focus on never overpaying. While this
does limit the company’s universe of acquisition candidates, it also ensures
that Berkshire only acquires operating businesses at what it judges to be a
reasonable price. The culture of Berkshire makes it the ideal acquirer for
many privately held or family owned businesses when the founder wants to
ensure that his or her business thrives into the future. The seller has the
11
- Acme Brick Company
- Applied Underwriters
- Ben Bridge Jeweler
- Benjamin Moore & Co.
- Berkshire Hathaway Group
- Berkshire Hathaway Homestates
Companies
- BoatU.S.
- Borsheims Fine Jewelry
- Buffalo NEWS, Buffalo NY
- Business Wire
- Central States Indemnity Co.
- Clayton Homes
- CORT Business Services
- CTB Inc.
- Fechheimer Brothers Co.
- FlightSafety
- Forest River
- Fruit of the Loom
- Garan Incorporated
- Gateway Underwriters Agency
- GEICO Auto Insurance
- General Re
- Helzberg Diamonds
- H.H. Brown Shoe Group
- HomeServices of America, a
subsidiary of MidAmerican Energy
Holdings Company
- International Dairy Queen, Inc.
- Iscar Metalworking Co.
- Johns Manville
- Jordan's Furniture
- Justin Brands
- Larson-Juhl
- Marmon Holdings, Inc.
- McLane Company
- Medical Protective
- MidAmerican Energy Holdings Co.
- MiTek Inc.
- National Indemnity Company
- Nebraska Furniture Mart
- NetJets
- The Pampered Chef
- Precision Steel Warehouse, Inc.
- RC Willey Home Furnishings
- Scott Fetzer Companies
- See's Candies
- Shaw Industries
- Star Furniture
- TTI, Inc.
- United States Liability Insurance
Group
- Wesco Financial Corporation
- XTRA Corporation
option of selling his or her business to a private equity firm and may not recognize the business a few
years later, or selling it to Berkshire and receiving assurance that it will still be essentially the same
business decades into the future. Certain sellers are willing to give Berkshire a more reasonable price in
exchange for the assurance that the business that an individual or family spent their lives creating will
continue to run in its current capacity long into the future. This opportunity to purchase at reasonable
prices entire privately held businesses that generate exceptional returns on capital will give Berkshire the
opportunity to continue to grow its portfolio of operating businesses well into the future.
Comparative Analysis: Berkshire Relative to Conglomerates
Evaluating Berkshire relative to other conglomerates will serve as another piece of the framework
within which Berkshire’s target price can be evaluated. The conglomerates chosen for comparison were
Leucadia National Corp. (LUK), Markel Corp. (MKL), Otter Tail Corp. (OTTR), Alleghany Corp. (Y),
and General Electric Co. (GE). Berkshire, Markel, and Alleghany all have significant exposure to the
financial sector, and specifically, the insurance industry. General Electric has limited exposure to the
financial sector through its Commercial Finance and GE Money segments. Leucadia and Otter Tail have
very little exposure to the financial sector, but serve as useful comparisons since they are conglomerates
like Berkshire.
Forward PE
Trailing PE
Price to EBITDA
Price to Sales
Price to Book
Price to Cash Flow
PEG Ratio
Return on Equity
BRKA
21.7
20.5
9.9
1.8
1.6
16.3
1.4
7.9
BRKA Relative to Conglomerates
OTTR
LUK
MKL
33.6
15.3
18.4
33.6
11.6
21.6
99.9
7.5
7.1
9.2
1.7
0.9
2.2
1.5
2.1
30.0
11.2
10.6
7.6
1.2
3.1
7.1
13.5
9.9
Y
14.9
14.9
6.2
2.2
1.1
14.0
3.5
8.0
GE
13.3
14.2
5.5
1.8
2.6
9.7
1.2
18.8
On the basis of earnings, Berkshire is near the expensive end of the group. Using this metric, it is
cheaper than only Leucadia and is very similarly valued to Otter Tail. General Electric, Markel, and
Alleghany all appear cheaper than Berkshire on the basis of earnings. However, when using the price to
book value metric, which is often used when evaluating conglomerates, Berkshire appears to be among
the cheaper conglomerates. While it is still more expensive than Alleghany, it is only slightly more
expensive than Markel on the basis of price to book value. Using this metric, it appears cheaper than
Otter Tail, Leucadia, and General Electric. It seems reasonable to conclude that Berkshire’s current price
places it in the middle of the group of conglomerates with respect to valuation. The financial stability of
Berkshire is unmatched by any of the other conglomerates, but aggressive investors may prefer a small
12
conglomerate such as Markel if they desire the potential for the types of return that Berkshire was able to
generate in the 1970s and 1980s. These investors must realize however, that in choosing Markel over
Berkshire, they would be trading a steady 10% to 15% return for significantly greater uncertainty. Given
Berkshire’s financial stability and the predictability of its earnings over the long-term, Berkshire seems to
be fairly valued relative to other conglomerates.
Comparative Analysis: Berkshire Relative to Insurers
Although Berkshire is a conglomerate, insurance premiums generated by its various insurance
businesses accounted for 26.9% of Berkshire’s revenue in 2007. Because Berkshire has such large
exposure to the insurance industry, evaluating its current valuation relative to major insurers will also be a
valuable piece of the investment framework within which Berkshire’s target price can be evaluated. A
diverse set of insurers was chosen since Berkshire has insurance businesses in each segment of the
insurance industry. The insurers chosen for comparison were American International Group (AIG),
Allstate Corp. (ALL), AXA (AXA), Allianz SE (AZ), ING Groep NV (ING), and Progressive Corp
(PGR).
Forward PE
Trailing PE
Price to EBITDA
Price to Sales
Price to Book
Price to Cash Flow
PEG Ratio
Return on Equity
BRKA
21.7
20.5
9.9
1.8
1.6
16.3
1.4
7.9
AIG
10.7
20.4
21.5
1.0
1.2
12.8
0.7
4.9
BRKA Relative to Insurers
AXA
ALL
8.7
8.3
8.4
11.4
5.3
6.4
0.8
0.5
1.4
1.2
7.2
11.4
1.1
1.4
16.2
10.1
AZ
7.4
18.4
3.6
0.6
1.2
14.3
1.8
6.7
ING
7.4
6.3
4.8
0.8
1.5
5.6
1.5
24.7
PGR
15.7
13.4
7.5
0.9
2.7
10.0
2.3
18.1
On the basis of earnings, Berkshire is the most expensive of the group of insurers. On the basis
of price to book value, Berkshire is the second most expensive insurer, with only Progressive being more
expensive. However, the PEG ratio places Berkshire in the middle of the pack of insurers, primarily due
to Berkshire’s higher projected earnings growth in 2008. The primary reason for Berkshire being more
expensive than its peers in the insurance industry is because of its exposure to industries outside of
insurance. As is discussed in the subsequent Risks and Concerns section of the paper, the outlook for
insurers in 2008 is quite unfavorable. Value Line describes the industry as “fiercely competitive”5 and
notes that this competition will place pressure on insurance premiums, margins, and profits in 2008.
Because Berkshire possesses unmatched financial stability in the insurance industry, is known for its
underwriting standards, has not suffered major write-downs like many of its insurance peers, and has
5
Gendler, Ian. "Berkshire Hathaway." Value Line. 15 Apr. 2008 <www.valueline.com>.
13
exposure to numerous industries outside of insurance, it deserves to trade at a premium to its peers in the
insurance industry.
Discounted Cash Flow Analysis
Income Statement Projection
Appendix 2 contains the income statement forecast and discounted cash flow model for Berkshire
Hathaway, yet another important piece of the framework within which Berkshire’s target price can be
evaluated. An emphasis was placed on conservatism in choosing estimates for 2008, 2009, and 2010, and
therefore, estimates were chosen that were conservative relative to their averages over the prior 5 years.
Key assumptions are listed below:
•
Operating Revenue: Historic growth rates of individual business segments were used with an
emphasis placed on risks to sustaining these levels of growth.
•
Insurance Losses & Loss Adjustment Expense: 19% was used for 2008, 2009, and 2010, which is
higher than the actual rates in 2007, 2006, and 2005 (17.77%, 13.26%, and 18.26% respectively)
to account for the possibility of large-scale natural disasters that would result in a significant
increase in the number of claims.
•
Tax Rate: Assumed a 32.75% tax rate.
•
Minority Interest and Growth in Average Common Shares Outstanding: Projected based upon
prior 5 years’ growth rates.
•
All other items were based on a percentage of revenue over the prior five years, with emphasis
placed on the likelihood of sustainability of recent growth rates.
These assumptions resulted in 2008 earnings per share of $7,525, relative to consensus of $6,851, 2009
earnings per share of $7,861, relative to consensus of $7,376, and 2010 earnings per share of $9,133,
relative to consensus of $12,300. It is notable that only one analyst has projected 2010 earnings per share
according to data provided by StockVal.
Discounted Cash Flow Model
Key Assumptions in the DCF model are listed below:
•
Terminal discount rate: 10%
•
Terminal free cash flow growth rate: 5%
•
Revenue growth: Faded to 5% by 2018
•
Operating margin: Remained at 13.50% through 2018
•
Tax Rate: Remained at 32.75% through 2018
•
Depreciation/Amortization and Capital Expenditures: Faded to offset by 2015
14
Although the DCF Model generates a target price of $170,300, I believe that my target price of
$145,000 is more reliable given the challenging economic conditions in which Berkshire will be
operating. In addition, because of the “conglomerate discount,” the tendency for conglomerates to trade
at a discount to the sum of the value of their parts, using a target price that is significantly below that
generated by a DCF analysis is conservative and appropriate.
Risks and Concerns
Key Manager Risk
The age of Buffett and Munger is a primary concern of many investors considering an investment
in Berkshire Hathaway. Buffett is currently 77 years old and will turn 78 on August 30, 2008. Munger
turned 84 on January 1, 2008. While both are in exceptional health by all accounts, it is apparent that
they cannot run Berkshire forever. They have assured investors that a succession plan is in place and
three top-notch individuals hand-picked by Buffett and Munger have indicated that they would be willing
to move to Omaha and run Berkshire whenever they are given the opportunity. Buffett’s current position
will be separated into two separate positions, Chief Executive Officer (CEO) and Chief Investment
Officer (CIO), to ensure that Berkshire has a specialist in each capacity. While Buffett and Munger are
undoubtedly irreplaceable, they have established a culture and mentality at Berkshire that will last for
decades after they are gone. Buffett has always said that he likes to buy businesses that are “so good even
an idiot can run them,” and to an extent, he has created such a business in Berkshire Hathaway. Even
when Buffett and Munger are no longer at the helm, Berkshire’s operating businesses will continue to be
run in a decentralized fashion as they are now. In addition, the investment portfolio of stocks that
Berkshire intends to hold forever will continue to consistently generate solid returns for decades to come.
The primary concern under new management will be allocation of new capital, which is no small concern
given the enormous amount of cash that Berkshire generates each year, but just as the size of Berkshire
prevents Buffett from producing the enormous returns of the 1960s and 1970s, the size would also make
it difficult for even a series of poor capital allocation or investment decisions to have a significant impact
on Berkshire.
Given the current discount at which Berkshire is trading in the market, it seems apparent that
there is zero “Buffett premium” built into the current price. In fact, if the ages of Buffett and Munger are
partially responsible for the current discount, there may in fact be a “Buffett discount” built into the
current price. The proposition of actually receiving a discount to have the greatest investment team ever
manage an investment portfolio for the rest of their lives seems like quite a favorable scenario for the
15
investor. Nonetheless, many investors are concerned that Berkshire’s shares will decline significantly
when Buffett or Munger passes away. Buffett has said on multiple occasions that he believes the deaths
of he and Charlie will present a buying opportunity for long-term investors. In addition, the $35.6 billion
of cash on Berkshire’s balance sheet as of March 31, 20086 serves as a sort of put option to a significant
share price decline in the event of Buffett and/or Munger being unable to lead the company. If the stock
declines as many investors expect it to when one or both of the managers pass away, Berkshire is likely to
utilize some of its $35.6 billion in cash to repurchase shares at the bargain price, which would create
significant long-term value for remaining shareholders. If Berkshire’s shares were to decline to a level
that the board judged to be unreasonably cheap, the company could also use its AAA credit rating to
borrow capital at a very low interest rate and repurchase shares at the sizeable discount from intrinsic
value, again creating tremendous value for remaining shareholders.
Insurance Industry
The lack of major natural disasters over the past few years has made the insurance industry
extremely competitive and has placed pressure on insurance premiums, margins, and profits. Because
Berkshire is known for having very strict underwriting standards, it is possible that revenues and earnings
generated by Berkshire’s insurance businesses could suffer in the short-term. However, Berkshire’s
strategy of only writing policies if it can profit on the policy itself, in addition to the float, is a prudent
long-term approach, and will prove beneficial to shareholders in the long run.
Another inherent risk in the insurance industry is the potential for large-scale natural disasters that
would be a significant drag on earnings in a given year. Because of Berkshire’s unmatched capital
structure, it is not at risk of these sorts of claims having a significant long-term impact on the company.
In fact, although natural disasters would be a short-term drag on Berkshire’s earnings, they would also
decrease the competition in the insurance industry and would allow Berkshire to realize greater
premiums, margins, and profits in subsequent years.
Even if Berkshire’s insurance businesses do experience challenges in the next few years, the
economics of the insurance industry are highly beneficial for a company with the capital structure of
Berkshire. The float on insurance policies equates to interest-free capital for Berkshire’s management to
strategically invest. When management is given capital at no cost, it has a very low bar that it must step
over to create additional value for shareholders. Assuming that the insurance businesses are able to
maintain their stringent underwriting policies, the float from insurance policies will serve as a constant
source of value creation for Berkshire shareholders.
6
Berkshire Hathaway 1st Quarter 2008 10-Q
16
Derivatives
Since reporting a $1.6 billion mark-to-market loss on derivatives in the 1st quarter of 2008,
Berkshire has been criticized for investing in what Buffett has referred to as “financial weapons of mass
destruction.” Although losses are never good, the $1.6 billion loss reported is merely a paper loss and is
unlikely to ever become a true loss. The loss results from put options that Berkshire wrote on four stock
indices, the S&P 500 and three foreign indices, in 2007. These put options were written at the money and
are not exercisable until expiration, which is between 2019 and 2027. Berkshire received $4.5 billion in
premiums for writing these options. Essentially, the company is predicting that come 2019 to 2027,
stocks will either be higher than they were in 2007 or at the same level. If this turns out to be the case,
Berkshire has made $4.5 billion on the put options despite the paper losses that occurred in the interim
periods. Although certain investors may choose to view this transaction as risky because of the interim
volatility, it seems like a pretty high probability event that stocks will at worst be flat over the next eleven
to nineteen years. If they happen to decline over this period, Berkshire has $4.5 billion in premiums to
cover any losses.
Conclusions
The combination of several factors makes Berkshire Hathaway an appealing investment candidate
at its current price of $123,970. This price is 17% below my conservative target price of $145,000 per
share and equates to a reasonable margin of safety for an investment in a company that possesses
unmatched financial stability and sustainable competitive advantages that characterize its operating
businesses and the businesses held in its investment portfolio. Several key aspects of my thesis are
summarized below:
•
The $35.6 billion of cash on Berkshire’s balance sheet as of March 31, 2008 will give the
company opportunities to strategically capitalize on the current market turmoil. During prior
economic downturns, the company has been able to create significant value for shareholders, and
it is not unreasonable to expect that management will be able to repeat this feat under current
economic conditions.
•
The financial stability of Berkshire is unmatched. The cash on its balance sheet, coupled with the
company’s minimal leverage, AAA credit rating, and consistent generation of sizeable free cash
flow makes Berkshire the ideal defensive investment.
•
Berkshire is a low-risk investment that will allow investors to profit from the eventual
turnarounds of the financial and housing sectors. It is unique to be able to benefit from these
turnarounds without assuming the risks that are associated with pure-play financial and
homebuilding stocks in the current economic environment.
17
•
At its current price, Berkshire has reasonable upside potential with minimal risk of permanent
loss of capital for the long-term investor. Berkshire is a very low risk proposition for the longterm investor, and when you don’t lose money, all of the other outcomes are good. The
opportunity to purchase Berkshire at a 17% discount to conservative intrinsic value provides a
reasonable margin of safety for an investment in a company of the caliber and stability of
Berkshire.
•
There is zero “Buffett premium” built into the current price and there may in fact be a “Buffett
discount” due the ages of Buffett and Munger. The proposition of actually receiving a discount to
have the greatest investment team ever manage an investment portfolio for the rest of their lives
seems like quite a favorable scenario for the investor.
•
Berkshire is a difficult company to value, which is often advantageous for the sophisticated
investor who is willing to work through multiple valuation techniques to establish a framework
within which a target price can be evaluated. Investors who are able to evaluate companies or
situations that others do not fully understand are often rewarded with healthy profits when other
investors later discover the value in a given company or situation.
In conclusion, Berkshire is admittedly not a deep-discount purchase at its current price, but it is
trading at a 17% discount to my conservative target price of $145,000. Several valuation methods
produced valuations that are significantly greater than my target price of $145,000, including the DCF
model, which produced a target price of $170,000. However, in the interest of conservatism and
acknowledging the conglomerate discount that has been evident in the markets over time, $145,000 seems
to be a reasonable target price. At its current price, I believe that an investment in Berkshire offers a very
high probability of consistent and reasonable returns to the long-term investor. The sizeable upside
potential coupled with minimal downside risk makes Berkshire Hathaway a prime investment for
investors with a long investment horizon.
18
Appendix 1: Berkshire Hathaway Financial Statements from Company 10-K
19
20
21
Appendix 2: Berkshire Hathaway Income Statement Forecast and Discounted Cash Flow Model
22
DCF Valuation
5/24/2008
Ticker: BRKA
Terminal Discount Rate =
Terminal FCF Growth =
Year
2008E
2009E
2010E
2011E
2012E
127,993
143,611
12.20%
163,138
13.60%
182,715
12.00%
200,987
10.00%
Operating Income
Operating Margin
17,919
14.00%
18,885
13.15%
22,024
13.50%
24,667
13.50%
Taxes
Tax Rate
Minority Interest
5,868
32.75%
400
6,185
32.75%
510
7,213
32.75%
625
Net Income
% Growth
11,651
12,190
4.6%
Add Depreciation/Amort
% of Sales
Plus/(minus) Changes WC
% of Sales
Subtract Cap Ex
Capex % of sales
2,560
2.00%
(128)
-0.10%
5,888
4.60%
8,195
Revenue
% Growth
Free Cash Flow
YOY growth
Terminal Value
NPV of free cash flows
NPV of terminal value
Projected Equity Value
Free Cash Flow Yield
523,729
96,378
166,876
263,254
3.11%
Shares Outstanding (mil)
$
123,970.00
Implied equity value/share
$
170,308.23
Upside/(Downside) to DCF
37.38%
Cash
Debt
44,329
53,472
Forecast
2013E
2014E
2015E
2016E
2017E
2018E
219,075
9.00%
236,601
8.00%
253,163
7.00%
268,353
6.00%
281,771
5.00%
295,859
5.00%
27,133
13.50%
29,575
13.50%
31,941
13.50%
34,177
13.50%
36,228
13.50%
38,039
13.50%
39,941
13.50%
8,078
32.75%
750
8,886
32.75%
875
9,686
32.75%
1,000
10,461
32.75%
1,125
11,193
32.75%
1,250
11,865
32.75%
1,375
12,458
32.75%
1,500
13,081
32.75%
1,625
14,186
16.4%
15,838
11.6%
17,372
9.7%
18,889
8.7%
20,355
7.8%
21,734
6.8%
22,988
5.8%
24,081
4.8%
25,235
4.8%
2,944
2.05%
(144)
-0.10%
6,750
4.70%
3,344
2.05%
(163)
-0.10%
7,749
4.50%
4,111
2.25%
(183)
-0.10%
7,765
4.25%
5,025
2.50%
(201)
-0.10%
8,039
4.00%
6,025
2.75%
(219)
-0.10%
8,215
3.75%
7,098
3.00%
(237)
-0.10%
8,281
3.50%
8,228
3.25%
(253)
-0.10%
8,228
3.25%
8,721
3.25%
(268)
-0.10%
8,721
3.25%
9,158
3.25%
(282)
-0.10%
9,158
3.25%
9,615
3.25%
(296)
-0.10%
9,615
3.25%
8,241
1%
9,618
17%
12,001
25%
14,156
18%
16,479
16%
18,936
15%
21,481
13%
22,720
6%
23,800
5%
24,939
5%
Terminal
P/E
EV/EBITDA
Free Cash Yield
37%
63%
1.545751
Current Price
10.0%
5.0%
23
Terminal
Value
523,729.1
20.8
10.75
4.76%