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Berkshire Coverage

Separating Investments From Operating Businesses No Berkshire-Valuation Panacea

In Part 3 of a 5-part series, Morningstar's Gregg Warren and Drew Woodbury say the so-called two-column approach to valuing Berkshire can be useful, but it also has significant shortcomings.

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Ahead of Saturday's  Berkshire Hathaway (BRK.A) (BRK.B) annual meeting we're taking a closer look at the best way to value the complex company. We believe that understanding the benefits and shortfalls of different methodologies can provide valuable insight into the ways in which different investors are approaching the firm's overall valuation. Part 1 of the series, discussing an earnings-based multiple approach, is available here. Part 2 on book value can be found here

The two-column approach to valuing Berkshire can be useful but is often misunderstood
The two-column method has become increasingly popular of late, and it has been publicly employed by a number of different market participants. Possibly most well-known for his use of this valuation method is Whitney Tilson from T2 Partners, who regularly updates and publishes a slide deck with his opinions on Berkshire Hathaway on his website. In addition to Tilson's method, there are a number of other ways to separate investments from the operating business in order to arrive at a more precise valuation model of Berkshire. Some of the approaches are not necessarily comprehensive in themselves but rather seek to overcome shortfalls of the previously mentioned approaches by supplementing a different valuation approach, such as seeking to overcome the difficulty of placing an earnings multiple on the insurance earnings by developing a valuation proxy for the insurance businesses. 

This approach has also become popular because of some implicit support from Buffett, who has repeatedly talked about separating the value of investments from the earnings of the operating businesses in a number of his annual reports. Though his comments have evolved somewhat over time, a notable example of this guidance on the calculation of intrinsic value can be found in Berkshire's 1997 annual report:

In our last two annual reports, we furnished you a table that Charlie [Munger] and I believe is central to estimating Berkshire's intrinsic value. In the updated version of that table, which follows, we trace our two key components of value. The first column lists our per-share ownership of investments (including cash and equivalents) and the second column shows our per-share earnings from Berkshire's operating businesses before taxes and purchase-accounting adjustments (discussed on pages 69 and 70), but after all interest and corporate expenses. The second column excludes all dividends, interest and capital gains that we realized from the investments presented in the first column. 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.

There are a number of ways in which the two-column approach is applied, but in general it involves separating the earnings of the operating business from the investment portfolio. How this specifically is done will vary. Some investors take the most literal interpretation and count the per share value of investments that Berkshire holds and attribute that value to shareholders. They then add the value of the remaining businesses, usually through a multiple of earnings excluding investments, to arrive at a total per share value. More recently, Buffett has suggested that the value of the insurance business is driven almost entirely by the investment portfolio and the returns it generates. Using this alternative interpretation, some have removed insurance earnings from the pretax earnings before ascribing a value to that portion of the company.

We believe taking the per-share book value of the investments and assigning that value to the insurance operations will substantially overstate the value of that business. In the table below we conduct a similar exercise for other publicly traded insurance companies. In our opinion, this table shows clearly that this approach dramatically overvalues insurance operations.

The problem with this approach in Berkshire's case, and in the case of nearly all financials and insurance companies, is that investments and cash are a required part of the operating business. The per-share value of the investments as reflected on the balance sheet is therefore not equivalent to their worth to shareholders. A discount needs to be applied to the per-share value of investments as reported by Berkshire, as in many cases these investments and cash are supporting reserves that are necessary for the insurance businesses. We believe this method tends to overestimate the value of Berkshire by effectively ignoring the policy obligations and other liabilities which support these investments.

That said, this approach could potentially be altered to provide a more realistic value in a couple of ways. First, we could discount the investments. An insurer's cost of equity is higher than the returns it can generate on its investments over the long term, and therefore the reported values should be discounted in order to determine their fair value to shareholders. For example, assume that a given insurance company has a cost of equity of 10% and has a $100 million investment portfolio that yields a return of 6% pretax in perpetuity (4.5% post-tax). The value of the investment portfolio to shareholders, after considering discounting, is then just $45 million, which is calculated by dividing the aftertax return by the cost of equity and multiplying by the size of the portfolio. Applying this method to other insurance companies generates a more reasonable result, but it still looks like a very imprecise method because we are completely ignoring disparities in underwriting income.

Other practitioners have sought to separate the excess cash and investments from the portion that is used to backstop the insurance operations, where the amount of float can serve as a proxy for required capital. Although we think this approach is better than simply taking the cash and investments on the balance sheet at par, issues still remain. Most notably, separating the float from the rest of the investments does not necessarily indicate the cash that is truly excess and available for shareholders. Berkshire routinely keeps more capital than is necessary to run its business, which gives it both financial flexibility to pounce on opportunities and superior financial strength. Therefore, it seems obvious that more cash and investments than simply the calculated float are implicitly required to run Berkshire. Buffett has commented that he will not let cash fall below $20 billion. This could be used as a rough approximation of cash and investments in excess of the float, but again, that would be the amount at which the company could no longer make acquisitions or other investments, which are arguably a core part of Berkshire's operations.

Greggory Warren does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.