What's the Best Way to Value Berkshire?
In Part 1 of a 5-part series, Morningstar's Gregg Warren and Drew Woodbury explore the pros and cons of using an earnings multiple to value Berkshire Hathaway.
Given its complexity, as well as the size and diversity of its businesses, valuing
Berkshire Hathaway (BRK.A) (BRK.B) is unquestionably a challenge. The most commonly cited methods for valuing the company's shares include the use of an earnings-based multiple, a book-value-based multiple, a two-column approach, a float-based methodology, and, finally, a discounted cash flow valuation. In some cases, investors will use a combination of these different methodologies to value different parts of the business, or as a way to triangulate their own estimates.
We believe that understanding the benefits and shortfalls of each of these methodologies can provide valuable insight into the ways in which different investors are approaching the firm's overall valuation. It also provides us with an opportunity to expand on our own discounted cash flow valuation, which we feel provides a more robust and reliable valuation than any of the other shortcut or alternative methods in use today.
Ahead of the annual meeting, we thought we would take an in-depth look at pros and cons of each of the most popular ways to value the company.
An earnings-based multiple is too simplistic and misses aspects of Berkshire's value
While a price/earnings-based multiple may work well when comparing similar companies in the same industry, there are no real comparable firms for Berkshire, which is basically a large collection of disparate companies operating independently of each other, making it difficult to determine which multiple would best reflect a fair price for the firm overall. Not only do we believe that a simple earnings multiple can lead investors astray because of the complexity and diversity of Berkshire's operations, but also some special difficulties exist with insurance company earnings, including the fact that they do not adequately capture the value of the firm's investments.
The table below highlights the price/earnings multiples as well as the multiples of our analysts' fair value estimates relative to their earnings estimates, for some of the publicly traded peer companies for Berkshire's main operating segments. We illustrate the diversity of Berkshire's operations and the difficulty of assigning good comparisons to the firm's disparate businesses (with the multiples across the different business lines varying fairly widely).
In order to apply these price/earnings multiples to come up with a value for Berkshire overall we need to break down the firm's pretax earnings by their different sources, as shown in the chart 3:
By combining this breakdown of Berkshire's pretax earnings by source with our fair value/earnings multiples (or with the price/earnings multiples in cases where a firm is not covered by a Morningstar analyst) we can produce a theoretical earnings-based multiple for the company, as shown below.
Notably, the multiple implied by this exercise is significantly lower than what we believe is a fair price for the company.
There are a few issues that can cause Berkshire's reported results to not reflect the full economic value of the company and therefore limit the usefulness of an earnings-based multiple approach. Most notably, annual earnings do not adequately reflect the full value of the company's equity investments (and to address this, some practitioners have suggested including "look-through earnings" to the valuation, an approach we will discuss later). On top of that, using an earnings multiple to value an insurance company has its own limitations, which we discuss in further detail below. Although Berkshire no longer derives as large a percentage of its profits from insurance as it once did, it still represents more than half of the value of the company, based on our analysis.
Annual earnings for insurance companies can be subject to significant volatility, which makes applying an earnings multiple a more difficult exercise. Insurance companies, and reinsurers in particular, are often subject to volatile claims that can cause earnings to fluctuate substantially from year to year. A hurricane loss or other significant storm could effectively wipe out an insurer's annual profits, while a year without major catastrophes could lead to abnormally high profitability. Berkshire's large reinsurance operations, concentrated in General Re and Berkshire Hathaway Reinsurance Group (BHRG), have significant exposure to large catastrophe and super catastrophe risks. Further, realized gains and losses on investments in Berkshire's insurance portfolios flow through the income statement, potentially distorting annual profitability. As such, it is not surprising to see a fairly wide spread in P/E multiples among the insurance peers listed in the comparison table above.
To address some of the shortfalls inherent in a simple earnings-based multiple, some investors have suggested incorporating "look-through earnings," which gives Berkshire credit for its proportional share of the earnings from the companies in its equity portfolio, into the process. Using this approach gets us closer to what we believe is a true value for Berkshire, but misses the mark slightly, as shown in the table below.
The differential of this approach from our fair value estimate may be due to a few factors. Most notably, the multiple we apply is the one derived from the proportional weightings of Berkshire's operating businesses. Due to the inclusion of financial businesses and certain high capital-intensity operations in the weighting, the multiple that gets assigned to Berkshire's subsidiaries is likely to be lower than the one that investors would assign to the firm's equity investments. Hence, an adjustment to the multiple may be needed. Additionally, except for the near-zero returns it generates, this method excludes the value of the firm's cash hoard. Another shortfall with this approach is that it treats all equity investments as if they are owned fully by shareholders. In reality (as we will elaborate on when we examine the two-column method), some of the investments are directly backstopping insurance operations that lessen their value to equityholders. There may also be some double counting as we are including some of the dividends earned from these equity investments that are already reflected in the firm's income statement.
Greggory Warren does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.