Book value is no longer a good


Book value was once one of the most widely used valuation techniques to determine the intrinsic value of companies through a value investing strategy, including Berkshire Hathaway, Inc. (BRK.A, Financial) (BRK.B, Financial). For a long time, investors and analysts have used this number to gauge whether investments might be undervalued in the market.

This is especially true for Berkshire. If we come back to check the roots, it is obvious that

Warren Buffett (Trades, Portfolio) has had an important role to play in this trend. In the 2011 annual letter to shareholders, the guru spoke about the Berkshire Hathaway valuation and wrote:

“We have no way of determining intrinsic value. But we do have one useful, albeit significantly underestimated, indicator of this: book value per share. This measure does not make sense in most companies. At Berkshire, however, the book value roughly tracks business values. This is because the amount by which Berkshire’s intrinsic value exceeds book value does not vary significantly from year to year, although it does. increases most years. Over time, the spread is likely to grow larger in absolute terms, while remaining reasonably stable on a percentage basis as the numerator and denominator of the business value / book value equation increases. “

Investing in the market, however, requires a lot of time spent tracking new developments at both macroeconomic and corporate level. More than eight years have passed since Buffett wrote this invaluable article, and Berkshire is no longer the company it was in 2011. This, combined with Buffett’s recent remarks, suggests that book value is no longer a precise representation of the reality with which the company is confronted.

The guru’s final remarks

Many market players are aware of Buffett’s remarks highlighted earlier, but not so much about how he went back on his 2011 suggestions in 2019. Below is an excerpt from Berkshire Hathaway’s 2018 annual letter to shareholders sent to investors on February 23. 2019:

Long-time readers of our annual reports will have noticed the different way I opened this letter. For nearly three decades, the original paragraph presented the percentage change in Berkshire’s book value per share. Now is the time to give up this practice.

The point is, the annual change in Berkshire’s book value – which makes its farewell appearance on page 2 – is a metric that has lost the relevance it once had. Three circumstances did it. First, Berkshire has gradually transformed from a company whose assets are concentrated in marketable stocks to a company whose primary value lies in operating businesses. Charlie and I expect this remodeling to continue on an irregular basis. Second, while our equity holdings are valued at market prices, accounting rules require that our collection of operating companies be included in the book value at an amount much less than their present value, an error that has become more pronounced. these last years. Third, it is likely that over time Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value. The calculation of these purchases is simple: each transaction increases the intrinsic value per share, while the book value per share decreases. This combination causes the book value dashboard to become increasingly disconnected from economic reality. “

The guru could not have explained more clearly why book value per share is no longer a reliable estimate of Berkshire’s intrinsic value. That being said, many investors continue to focus on this number because of what Buffett wrote earlier in 2011, which I feel is inaccurate and counterproductive given the analysis provided by the number one insider of the company.

An alternative valuation technique

A sum of the valuation of coins seems to me to be the best way to determine the value of Berkshire. To properly use this mechanism, an investor must take an ownership perspective and find the value of Berkshire holding companies.

To do this, an investor can choose an appropriate technique depending on the valued company. For example, the conglomerate’s stake in Bank of America Corporation (BAC, financial) can be assessed using an asset-based approach, whereas a company like Apple, Inc. (AAPL, financial) may need to be assessed using a discounted cash flow approach.

Once the intrinsic values ​​of the percentages of Berkshire’s stake in its investments and the total values ​​of its constituent companies (such as insurance business, BNSF, etc.) are calculated, the investor can deduce a proportional value that should be reflected in the Berkshire books. The last step is to add up all of these values ​​to find the total value of Berkshire.

Morningstar uses a similar approach to find the true value of Berkshire. In a report highlighting his approach, Morningstar analyst Greggory Warren wrote:

“We use a sum of parts methodology that values ​​different companies separately and then combines those values ​​to come up with a total value for Berkshire Hathaway. As part of this process, we use discounted cash flow methodologies to assess each of the main segments of the business: insurance operations (including the investment portfolio attached to this activity), BNSF, Berkshire Hathaway Energy, and manufacturing, service and retail operations. “

Here is an illustration of the value calculated by the analyst for the two classes of Berkshire shares:

Source: Morning Star

Even though book value has been a reliable indicator of business value in the past, things might not be the same. For this reason, investors should research complex valuation techniques to find the true value of Berkshire stocks in order to successfully identify potential investment opportunities.

The title seems to be undervalued by 2021

Berkshire Hathaway was among Barron’s Top 10 Stock Picks for 2021, a list that many investors follow closely for attractive investment opportunities. The company’s unique position makes it both a defensive game and a bet on the recovery of the global economy.

For example, Berkshire has a massive stake in Apple, which should perform better if consumer spending grows as expected in 2021. On the other hand, the $ 1 billion stakes in companies such as The Kraft Heinz Company (KHC, Financial) make Berkshire a defensive game that could withstand a severe economic downturn. It is also one of the characteristics appreciated by Barron’s.

Another factor of shareholder value is the share buyback program. During the third quarter, Berkshire repurchased a record $ 9 billion of its shares, which will help the company post better earnings per share in the years to come. In addition, buybacks are a source of income, and long-term investors will reap the rewards from billion dollar share buybacks. On top of that, Buffett’s decision to buy back the Berkshire stock involves his belief that the stock is significantly undervalued.

Value stocks, in general, appear to be undervalued as growth strategies continue to outperform, and any return in value will provide a solid platform for Berkshire to deliver exceptional returns to long-term investors.

To take with

Berkshire Hathaway, one of the world’s most followed companies, appears to be undervalued at the dawn of a new year.

While growth-oriented investors may want to wait for a better opportunity given the company’s mediocre growth expectations of many hot names, value investors should be happy with what they see.

Buffett sends a clear signal to the market by buying back billions of dollars of Berkshire shares, prominent Wall Street analysts believe the stock is a good deal at the current price point and strategies are expected investment value come back strongly in the future. . With more than $ 140 billion in cash, the company is well positioned to double the investment opportunities that may arise. Given all of these positive developments, I find it hard to argue with the conclusion that Berkshire is a good value investment.

Disclosure: The author owns shares in The Kraft Heinz Company.

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