Thursday, May 31, 2012

Berkshire's Book Value & Intrinsic Value

Since the end of 1999, Berkshire Hathaway's (BRKa) per share book value has grown from $ 37,987 to $ 99,860 at the end of last year (a 163% increase).

1999 Berkshire Letter

A little more than 2 months into the next year, the NASDAQ closed at its peak of 5,048.

Not long after that, the S&P 500 closed at its peak up to that point of 1,527.

Berkshire Hathaway's stock (Class A) was selling at $ 41,300/share back then.
(When the NASDAQ hit its peak.)

So price to book value back then was 109% of book value.

Price to book value = $41,300/$ 37,987 = 109%

It didn't remain at that level for long.

At yesterday's close, Berkshire's stock was selling at $ 119,250.
(A 189% increase since the NASDAQ hit its peak.)

That puts price to year end 2011 per-share book value closer to 119%.
(Actually it would be a bit cheaper using book value from the end of the 1st quarter...more like 112%.)

So Berkshire's book value and stock performed relatively well in a period when most major indexes performed poorly (to say the least).* Of course, what's most important is whether intrinsic value has increased.

Changes in book value, according to Warren Buffett, is not a bad way to estimate Berkshire's intrinsic value.

From the Berkshire owner's manual:

Inadequate though they are in telling the story, we give you Berkshire's book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire's intrinsic value. In other words, the percentage change in book value in any given year is likely to be reasonably close to that year's change in intrinsic value.

Buffett has been clear when they'll buyback the stock. Here's what he wrote in the latest shareholder letter:

At our limit price of 110% of book value, repurchases clearly increase Berkshire's per-share intrinsic value. And the more and the cheaper we buy, the greater the gain for continuing shareholders. Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower.

So Buffett obviously considers Berkshire's intrinsic value to be much higher than 110% of book value** but, of course, doesn't say by how much.

What may seem at least somewhat surprising (in today's valuation context) is that, for much of the mid-to-late 1990s, the Berkshire's valuation spent most of the time at 200% of book value and even, at times, more than 300% of book value. Those valuation levels made it very difficult for investors who bought at that time to get satisfactory long-term returns.

Well, at least they were destined to returns that were less than the intrinsic value that Berkshire would create.

In fact, the stock was overvalued enough so in 1996 that Berkshire issued the following warning in its prospectus for the Class B Common Stock:

WARREN BUFFETT, AS BERKSHIRE'S CHAIRMAN, AND CHARLES MUNGER, AS BERKSHIRE'S VICE CHAIRMAN, WANT YOU TO KNOW THE FOLLOWING (AND URGE YOU TO IGNORE ANYONE TELLING YOU THAT THESE STATEMENTS ARE "BOILERPLATE" OR UNIMPORTANT)...

The prospectus then added...

Mr. Buffett and Mr. Munger believe that Berkshire's Class A Common Stock is not undervalued at the market price stated above. Neither Mr. Buffett nor Mr. Munger would currently buy Berkshire shares at that price, nor would they recommend that their families or friends do so.

and...

In recent years the market price of Berkshire shares has increased at a rate exceeding the growth in per-share intrinsic value. Market overperformance of that kind cannot persist indefinitely.

Unlike the 110% of book value that Buffett now seems to consider a reasonable price to pay for Berkshire, those shares were being offered back then at more like 200% and, as the chart in this article shows, even higher.

The per-share book value back when the Class B Common Stock was being offered to the public was $ 14,426. So per-share book value has increased nearly 7-fold since then to $ 99,860 at the end of 2011. Since, as Buffett says, book-value is a rough "albeit significant understated" estimate of intrinsic value it's not a bad if possibly somewhat conservative way to see how much value has been created over that time frame.

Other thoughts:

- It would be nice if guidance on valuation like the one in the Berkshire prospectus was closer to the norm but I suspect that won't be happening anytime soon. Getting the price as close to intrinsic value as possible would allow new long-term owners, alongside existing long-term owners, to make a return roughly consistent with how the business performs (whether it creates or destroys intrinsic value). If new owners pay a price for shares well above intrinsic value they, by definition, will have returns less than what the business itself produces in value over time (unless somehow shares were also sold well above intrinsic value). 

- Obviously, it's no surprise those selling shares to the public attempt to raise money at the highest price possible. That's not going to suddenly change. I'm just suggesting an effective process with some integrity to it would often find a good balance. Existing owners would get a fair price for the portion of the business they are selling, while the new partner-owners pay something close to what the business is actually worth. It's not just because this might improve how effectively capital is formed and allocated. It's because those who'd like to establish a healthy long-term oriented ownership culture among its investors should want it. CEOs can play a role in guiding investors in the same manner Buffett attempted to do in the Class B Common Stock prospectus (even though it didn't work in that case). I realize many buy shares of an IPO to flip for quick profit, but the process could better serve those who are willing to put capital at risk with a company's long-term prospects in mind.***

- Due to its sheer size, Berkshire can't generate wealth as fast as it did in the past but still created wealth at nice clip during a period when most major indexes could not. I'm guessing it will do just fine going forward.

- Since 2000, many good businesses that make up the S&P 500 increased their intrinsic value much more than the index would suggest. The index underperformed for the straightforward reason that many stocks in the index were selling above intrinsic value back then. So naturally performance of the index suffered as intrinsic value caught up to price. Berkshire just happened to be hitting valuation lows, and was selling at a reasonable price compared to intrinsic value, when the NASDAQ and S&P 500 were hitting their highs.

When a particular stock seems to have been dead money for an extended period, it is sometimes useful to see if that's because the business hasn't performed, or the result of coming into a particular period overvalued.

Check out page 99-100 of the 2011 annual report for a good explanation of how Warren Buffett and Charlie Munger view Berkshire's intrinsic value.

Adam

Long BRKb

* Both indexes are obviously still selling below their peaks in 2000 (down 44% for the NASDAQ but only 14% for the S&P 500). At least the dividends make the picture a little less ugly but more so for the S&P 500.
** 110% of the book value or a 10% premium over the book value. It's been described both ways in different publications.
*** Buffett tried to make it clear Berkshire's stock was expensive but the shares were still purchased by many at that very high valuation. So, if the environment is sufficiently euphoric, it's not easy to discourage plainly expensive shares relative to approximate intrinsic value from being purchased. In addition, a less proven business than Berkshire (even those with exciting prospects) are, by their nature, more speculative and have difficult to estimate per share intrinsic value. Yet, in many cases I think knowing what's reasonable is more obvious than some might admit.
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