Berkshire Hathaway

I'm slightly incredulous, but it appears that Berkshire Hathaway shares are moving into value territory. The B shares traded below $2700 for much of Friday, although they closed at $2900. It's slightly tricky to work out a fair value for Berkshire, but worth having a stab. If you can buy $1 for 80 cents and have it managed by the world's most successful investor for free, then you're doing well.

A and B shares
The Berkshire B shares are worth 1/30 of the economic value of the A shares, but hold 1/200 of the voting rights. A shares can be converted into 30 B shares, but not vice versa. Owing to the lower face value, the B shares are far more liquid.

There are 1.08m A shares and 14m B shares, so an equivalent of 1.55m A shares.

Pots of value
Warren Buffett lays out the basis for his own valuation of Berkshire in his annual report. There are two "pots of value". Firstly investments in stocks, bonds and cash, partly funded by "float" from Berkshire's insurance operation. The second pot of value is Berkshire's wholly owned businesses, which appear on the balance sheet at far below fair value.

At 2007 year-end, Berkshire report $141bn of investments, funded by $59bn of float. This works out to $90343 per share. Pre-tax earnings per share for wholly owned businesses were $4093.

Float
How you calculate the float liability is debatable, but since Berkshire has historically made money on its insurance operation, the float has been better than free. An interest-free loan that never needs to be repaid is worth precisely the value of the loan. An interest-free loan that never needs to be repaid and grows over time is worth even more - but let's be cautious and assume float will remain at approximately $59bn, so simply write this off as a liability when considering value.

Balance sheet
It's important to check out the balance sheet to see whether Berkshire are fibbing about their two pots of value. Shareholder equity is $120bn. Writing off goodwill leaves $87bn. That's roughly what you'd expect from the $141bn of investments minus $59bn of float.

Value calculation
Valuing Berkshire's wholly-owned businesses is a bit tricky, but I'm going to put a pre-tax P/E ratio of 10 on them. That equates to about 15 after tax, reflecting the fact that I think they are largely high return-on-equity, strongly cash-generative, stable, successful businesses with a good moat. I don't think Buffett buys any other sort.

I'll value the investments at their face-value (although we'll need to adjust for the current state of the market) and write off the float as a liability, on the basis that it costs nothing and will not need to be repaid in the foreseeable future.

Before adjusting for 2008's changes in value, that leaves us with a value per-share of $90343 + $40930 = $131273. That's $4375 per B share. At the end of 2007, the actual share price was $141000, so pretty close to fair value. Since 2002 Berkshire has traded within about 10% (plus or minus) my idea of fair value.

Book value multiplier
We may be able to approximate the change in value of Berkshire by the change in book value. In order to study this I've pulled data from their annual reports since 2001. My fair value calculation has been fairly consistent at 1.6 times their book value. That makes a handy proxy for current value.

Equities in 2008
Now we come to the interesting bit. Sticking Berkshire's shares into a Yahoo finance portfolio, I reckon their current value is approximate $50bn, vs. $75bn at the start of the year. So barring any changes to the portfolio, Berkshire is down a massive $25bn so far this year. Crucially, rather a lot of that has come since the end of September, so wasn't reported in the last quarterly report. I'd estimate that around $15bn has been wiped off Berkshire's equity portfolio since the end of September. Their quarterly report estimates $9bn by the end of October, and things have got somewhat worse since then, so that tallies.

Current fair value
Based on the latest estimates share prices, book value per A share is about 67750. Applying the same 1.6 multiplier and extrapolating to the B shares, fair value is about $3610.

Alternatively estimating current investments and assuming no earnings change for wholly-owned companies, fair value is about $3910.

The divergence here is because in one valuation method $15bn is wiped off investments, and counts once, and in the other it is wiped off book value and multiplied by 1.6.

Let's call current fair value $3750 as a compromise.

Desirability of investing in the US market
Despite my calculations suggesting fair value has declined from $4200 to $3750 in the last 2 months, I don't think the "actual" value has changed much. The US market has been overvalued and is only now approaching a reasonable level. In the last year or two I would have looked for a very substantial discount before buying, I'm now prepared to accept a more modest discount. So my buying price has probably changed little - a 30% discount at end-2007 is the same as a 16% discount now.

$3000 is a 20% discount to my current fair value. $2600 is a 30% discount.

To buy or not to buy
Right now I have way too much US$ exposure, so I'm not a buyer yet. But in 1 month my dollar exposure will be halved, and at that point I would definitely be a buyer at $2600, possibly even at $3000.