Book value was once one of the most widely used valuation techniques to determine the intrinsic value of companies via a value investing strategy, including Berkshire Hathaway, Inc. (BRK.A, Financial) (BRK.B, finance). Both investors and analysts have long used this number to gauge whether assets may be undervalued in the market.
This is especially true for Berkshire. If we go back to check the roots, it’s obvious
Warren Buffett (Trades, Portfolio) played a significant role in this trend. In the 2011 annual shareholder letter, the guru elaborated on Berkshire Hathaway’s valuation, writing:
“We have no way of accurately determining intrinsic value. But we do have a useful, if grossly understated, proxy for this: book value per share. This benchmark is meaningless for most companies. However, at Berkshire, book value roughly reflects enterprise value. That’s because the amount by which Berkshire’s intrinsic value exceeds book value doesn’t vary widely from year to year, although it increases most years. Over time, the variance is likely to increase in absolute terms, but remain fairly constant, as a percentage, as both the numerator and denominator of the business/book equation increase.”
However, investing in the market requires a lot of time to follow new developments both at the macroeconomic level and at the corporate level. It’s been more than eight years since Buffett wrote that invaluable article, and neither is Berkshire the company it was in 2011. That, combined with Buffett’s recent comments, suggests that book value no longer accurately reflects the reality facing the company.
The Guru’s Recent Remarks
Many market participants are aware of Buffett’s previously highlighted remarks, but not as many tuned in to how he rolled back his 2011 proposals in 2019. The following is an excerpt from Berkshire Hathaway’s 2018 annual shareholder letter, which was mailed to investors on Feb. 23. 2019:
“Longtime readers of our annual reports will have noticed how differently I opened this letter. For almost three decades, the first paragraph showed the percentage change in Berkshire’s book value per share. It is now time to abandon this practice.
In fact, Berkshire’s annual change in book value — which appears on page 2 in farewell — is a metric that’s lost its relevance. Three circumstances led to this. First, Berkshire has gradually transitioned from a company whose fortunes are concentrated in marketable stocks to one whose greatest value is in its operations. Charlie and I assume that this transformation will continue irregularly. Second, while our investments are valued at market prices, accounting regulations require that our collection of operating companies be included in book value at an amount well below their current value, an error that has increased in recent years. Third, it’s likely that Berkshire will be a significant buyback of its shares over time, transactions that will occur at prices above book value but below our estimate of intrinsic value. The math of such purchases is simple: Each transaction increases intrinsic value per share while decreasing book value per share. This combination causes the book value scorecard to diverge more and more from economic reality.”
The guru couldn’t have thought clearer about why book value per share is no longer a reliable estimate of Berkshire’s intrinsic value. However, many investors continue to focus on that number because Buffett wrote in early 2011, which I find inaccurate and counterproductive given the analysis provided by the company’s number one insider.
An alternative scoring technique
A sum of parts valuation seems to me the best way to determine Berkshire’s value. To properly utilize this mechanism, an investor must take an ownership perspective and determine the value of Berkshire’s holding companies.
To do this, an investor can choose a suitable technique depending on the company being valued. For example, the conglomerate’s stake in Bank of America Corporation (BAK, Financial) can be valued using an asset-based approach, while a company like Apple, Inc. (AAPL, Financial) may need to be valued using a discounted cash flow approach.
Once both the intrinsic values of Berkshire’s percentage ownership in its investments and the full values of its constituent companies (like the insurance business, BNSF, etc.) are calculated, the investor can derive a proportional value that should be reflected on Berkshire’s books . The final step is to add all of these values together to come up with Berkshire’s overall value.
Morningstar takes a similar approach to determining Berkshire’s true worth. In a report highlighting his approach, Morningstar analyst Greggory Warren wrote:
“We rely on a sum-of-the-parts methodology that scores the various companies separately and then combines those scores to arrive at an overall score for Berkshire Hathaway. As part of this process, we use discounted cash flow methods to value each of the company’s major segments: the insurance business (including the portfolio of investments associated with that business), BNSF, Berkshire Hathaway Energy, and the manufacturing, service and retail businesses.”
The following is an illustration of the analyst’s calculated value for the two classes of Berkshire stock:
Source: Morning Star
While book value has historically been a reliable indicator of a company’s value, this may no longer be the case. Because of this, investors must look to intricate valuation techniques to determine the true value of Berkshire stock and successfully identify potential investment opportunities.
The stock looks undervalued into 2021
Berkshire Hathaway made it into Barron’s top 10 stock picks for 2021, a list that many investors eagerly follow to find attractive investment opportunities. The company’s unique position makes it both a defensive play and a bet on the global economy’s recovery.
For example, Berkshire has a massive stake in Apple, which is bound to do better if consumer spending picks up as expected in 2021. On the other hand, the multi-billion dollar stakes in companies like The Kraft Heinz Company (CHC, Financial) make Berkshire a defensive stock that could weather a severe economic downturn. This is also one of the qualities Barron’s loves.
The share buyback program is another value driver for shareholders. During the third quarter, Berkshire repurchased a record $9 billion of stock, which will help the company report better earnings per share for years to come. Also, buybacks are a source of revenue, and long-term investors will reap the rewards of billions of dollars in share buybacks. Additionally, Buffett’s decision to buy back Berkshire shares implies his belief that the stock is significantly undervalued.
Value stocks generally appear undervalued as growth strategies continue to outperform, and an eventual return of value will provide Berkshire with a strong platform to provide investors with excellent returns over the long term.
Bring away
Berkshire Hathaway, one of the world’s most traded companies, appears to be undervalued as the new year begins.
While growth-oriented investors might want to wait for a better opportunity, given the company’s lackluster growth expectations compared to many red-hot names, value investors should be excited by what they’re seeing.
Buffett is sending a clear signal to the market by buying back billions of dollars worth of Berkshire, prominent Wall Street analysts believe the stock is a steal at current price levels, and value investing strategies are expected to will come back strong in future . With over $140 billion in cash, the company is well positioned to double down on any good investment opportunities that might arise. Given all of these positive developments, I have a hard time arguing with the conclusion that Berkshire is a good value investment.
Disclosure: The author owns shares in The Kraft Heinz Company.
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