Berkshire Hathaway Inc. Stock Report

Berkshire Hathaway Inc.

Note that our graphs almost always use log scales. (The only exception is when we have negative earnings to deal with, which can’t be shown on a log scale). On normal arithmetic scales any growth at all can be made to look like a huge slope (from left bottom corner to top right corner). On log scales it takes truly strong growth to achieve much of a slope. Consider that the distance between major points on this log scale is ten times or 1,000%.

Berkshire’s Book value per share (the green line) has grown fairly strongly at a compounded average of 9.5% per year since 2006. This is good but unspectacular growth given that there is no dividend. Berkshire’s revenue per share (the red line) has shown relatively strong growth averaging 8.0% per year, also good but unspectacular. The GAAP earnings (blue line) dipped sharply in 2008 due to investment losses and lower insurance profits but has grown strongly since then but overall has compounded up at only 4.4% annually since 2006. The adjusted earnings per share (pink line) eliminates realized gains and losses on investments has compounded up at only a modest 4.2% annually since 2006. However, both GAAP and adjusted earnings were had spiked hugely compared to the previous few years which may largely explain the low growth since then.

In the case of Berkshire, adjusted earnings are consistently under-stated since it ignores realised investments gains and losses which although volatile and sometimes negative have been positive and material on average over the years. Adjusted earnings also include only the dividends on the large investments in companies like Coke and not a full share of earnings of those companies. Adjusted earnings also reflects income tax at a recent rate of 31% although when net deferrals of income tax (this year’s deferral minus any reversals of prior year deferrals) are considered the cash tax rate is closer to 20%.

The book value per share gain may be the best performance indicator in the case of Berkshire.

Berkshire Hathaway Inc. (BRKB, New York)
Report Author(s):  InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  Author(s) hold shares
Based on financials from: Dec ’16 Y.E.+ Q3 ’17
Last updated: 07-Nov-17
Share Price At Date of Last Update: $186.21
Currency: $ U.S.
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual):  (lower) Buy rated at  $186
SUMMARY AND RATING:  The graph shows that revenues and book value per share have grown strongly over the ten years shown on the graph. But GAAP and adjusted (operating) earnings  have seen relatively modest growth in the ten years shown. Importantly, Berkshire is reasonably predictable (in the long term) and can be expected to continue to grow over the years. The value ratios are difficult to interpret due to the difficulty of identifying the current normalized earnings level but would appear to justify only a Weak Buy or (lower) Buy rating at this time. Management is exceptional. The long term outlook is positive given its competitive advantages.  The very recent earnings trend is negative while the revenue per share trend is quite positive.  There is no insider trading signal at this time.  Buffett has pointed out that book value includes deductions for deferred income tax, for the insurance float liabilities and for amortization of customer lists and trademarks. But in the case of Berkshire (unlike most insurance companies) the cost of the float has been negative most years (but will be a positive cost in 2017) and it regenerates year after year. So it can be discounted greatly as a liability. Similarly deferred income taxes incur no interest and tend to grow over the years and again can be discounted as a liability. Proposed income tax cuts could cut the deferred tax liability very significantly which we estimate could, if enacted, provide a one-time boost to book value per share of about 11% as well as ongoing benefits of a lower tax rate. Overall, we would rate this a (lower) Buy at $186.21.
DESCRIPTION OF BUSINESS: A HUGE operating and investment company. The employee count was 361,000 at the end of 2015.  It’s number 4 (by revenue) on the 2014  Fortune 500 list. Its equity value places it at number 4 world-wide on the list of publicly traded companies. In 1965, Warren Buffett took control of the then large but very much declining textile company and proceeded to transform it into a holding company for investments including wholly owned subsidiaries.  In 1967 Buffett had Berkshire purchase National Indemnity an Omaha-based insurance operation. Insurance companies generate funds for investment and this move transformed Berkshire into a stock investing company. Buffett had wrung the cash for this purchase out of the declining textile operation by reducing inventory and collecting receivables and through good operational management and through a early period of high profits. No dividends are ever paid as all earnings are retained and have been invested at very attractive rates of return. As of the end of 2015 Buffett’s strategies have resulted in the share price climbing 1.6 million percent since 1965 and the book value per share had risen 799,000% (or 8000 times). These are completely unprecedented and almost unfathomable results. The S&P 500 meanwhile, including reinvested dividends, had returned 11,355% in the same time period. In 2015 the breakout of the net earnings by segment was: insurance including dividends and interest on insurance investments 28%, manufacturing, service and retailing 27%, railroad 24%, utilities 12% and lending and leasing 8%. This excludes gains and losses on investments which are positive on average but are negative some years. The insurance operations provide substantial funds for investments which are held mostly in equities and in wholly owned businesses. Deferred income taxes also provide substantial funds for equity investments. The strategy is to invest in companies that are stable and can be predicted to continue to earn excellent profits, that have excellent (and likable and ethical) management, and that are available at good prices. The preference is to buy entire companies, usually these are private companies but some have been taken private by buying all the shares on the stock market. These buys are forever. Subsidiary companies once bought are never sold. As an alternative to buying entire companies, shares in companies with similar qualities are purchased. These are sometimes later sold but the intention is typically to hold for a long time. The corporate culture includes the highest in ethics, deep respect for investors and includes being efficient. Managers are highly incented (both financially and emotionally) to be as efficient as possible and make high returns on capital. The use of debt is generally discouraged or minimised except in lending (financing) operations and in the railroad and utilities. The company is highly decentralized. Head office is involved in large capital spending decisions and in selecting, motivating  and compensating the top manager at each subsidiary. The goal of the company is the grow intrinsic value per share over the long term at a rate higher than the total returns on the S&P 500. Long term profit is never ever sacrificed for the sake of short term profits or currying favor with analysts or investors in any way.
ECONOMICS OF THE BUSINESS: In insurance Berkshire concentrates on areas where it has a cost advantage (Geico through direct selling) or where its huge financial resources provide a competitive advantage and where others fear to tread (reinsurance and the writing of massive policies) or where the business is extremely long tailed (workers compensation) to take advantage of Berkshire’s investing prowess. In insurance Berkshire retains all its earnings and uses this to build up an equity ratio far higher than regulators require and debt is shunned. This provides an unusually strong (for the insurance industry) balance sheet which allows the company to invest both the insurance premium and its own equity mostly in equities for their higher returns (the higher risk of equities is offset by the Gibraltar like financial strength). In addition to stocks and bonds, wholly owned companies are often purchased through the insurance operations. All of the equity investments whether wholly owned or not tend to be in stable predictable businesses that are well managed and have good economics. The rail business economics are strong in that the business grows predictably with the economy, rail has cost advantages over trucking and many customers may face limited or no other choice. The utility business is a regulated monopoly and so earns steady but unspectacular earnings. Both rail and utilities have the need for and the opportunity to invest large additional capital amounts. The Finance and Financial products consists of loans to buyers of its manufactured homes as well as various investing operations that Berkshire undertakes outside of its insurance operations. The economics of finance are good but requires discipline and brains to avoid big mistakes.
RISKS: As a huge conglomerate, the risks are too numerous to list here. Please see the annual report. Some important risks are the risks of large losses in insurance due to earthquakes,  hurricanes and terrorist attacks. Also the stock price would likely drop at least temporarily on the ultimate death or retirement of Warren Buffett.
INSIDER TRADING / INSIDER HOLDING: We understand that Warren Buffett has never sold a single share except for transfers as gifts, including recently to charity. Yahoo Finance is not showing any recent insider activity (although it may just be out of date) and therefore the insider trading signal is neutral.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand and is predictable (fail, it is a huge conglomerate and its insurance operations are complex), has favorable long-term economics due to cost advantages or superior brand power (pass as Buffett has always bought such businesses for Berkshire and its core insurance business passes the test as well), apparently able and trustworthy management (pass given Buffett’s reputation), a sensible price – below its intrinsic value (marginal pass at best), Other criteria that have been attributed to Buffett include: a low  debt ratio (pass), good recent profit history (marginal pass with modest ROE) little chance of permanent loss of the investors capital (pass) a low level of maintenance type capital spending required to maintain existing operations excluding growth (marginal pass as the rail and utility businesses require constant capital spending)
MOST RECENT EARNINGS AND SALES TREND:   Note that revenue and earnings growth is impacted by “lumpy” gains and occasional loses on investments disposed of. In the four most recent quarters beginning with the most recent (Q3 2017) revenues per share rose 2%, 6%, 24% and 11% while operating earnings per share (which exclude gains and losses and are affected by lumpy insurance results) fell 29%, fell 11%, fell 5% and fell 6%. Revenue per share in 2016 grew 6% and operating earnings per share grew 1%. Revenue per share in 2015 grew 8% and operating earnings per share grew 5%. Revenue per share in 2014 grew 7% and operating earnings per share grew 9%. By nature the revenue and adjusted earnings are “lumpy” making the trend difficult to interpret. Overall the very recent trend in operating earnings is weak while the revenue trend is strong.
Earnings Growth Scenario and Justifiable P/E: It is difficult to comment on the P?E ratio since the earnings are quite lumpy and it is difficult to judge what its normalized earning are at this time. But if we assume its normalized earnings are 8% of book value annually then the current share price is pricing in about a 10% annual growth in earnings with a terminal P/E of 16.
VALUE RATIOS: Analysed at a price of $186. Price to book value ratio seems neutral in attractiveness at 1.49 (although many financial and holding companies tend to trade at low multiples to book value, and keep in mind that book value includes a substantial amount of purchased goodwill). The price to tangible book value is less attractive at 2.02. Buffett has indicated each year in annual letter since 2013 that intrinsic value of the shares significantly exceeds 1.20 times book value but it’s not entirely clear if he would put the value past 1.49 times. Berkshire will aggressively buy back shares if the price dips below 120% of book value (that is, below $150). The most important value ratios are usually based on a view of adjusted earnings which ideally is a base level from which we can project a growth or decline. Berkshire provides a view of operating earnings that excludes all gains on securities sales. This adjusted figure is conservative because although gains are volatile, they are positive in the great majority of years. It also ignores the fact that a material portion of its income taxes is ersatz in that deferred income taxes are continually growing and some goodwill-like intangibles are being amortized which reduces earnings. This means that the adjusted P/E is “artificially” high and the adjusted ROE is “artificially” low. On that basis, the adjusted (operating earnings) P/E is nominally quite unattractive at 29.6.   The adjusted ROE in the past 12 months is ostensibly not attractive at 5.4%. Adjusted ROE on (ending) equity less goodwill ( a measure Buffett favors) is moderately attractive at 6.8%.   The P/E based on unadjusted GAAP earnings is unattractive at 24.6. We have introduced a new view of adjusted earnings that is 10% of book value on the basis that book value has grown at an average of just under 10% in the past ten years and this reflects the average investment gains. This is arguably conservative as it does not consider the benefits of deferred taxes and does not add back amortization of goodwill-like intangibles. On this basis the ROE is obviously 10% and the P/E is reasonably attractive at 15.0. There is no dividend because all earnings are retained for reinvestment.(Buffett would not retain all earnings if he thought the ROE on reinvestments was inadequate.) Revenues per share have grown at an average of 9.3% in the past five calendar years. Operating earnings have grown at an average of 10.4% per year over the past five years. Intrinsic value based on adjusted earnings (using our newer approach of 10% of book value) is estimated at $166 based on five-year 7% growth and a final P/E of 13 and $235 based on five-year 10% annual growth and a final P/E (on that earnings basis) of 16.  (These values fall to $133 to $188 if we assume an 8% ROE rather than 10%) These value ratios are hard to interpret but would support  perhaps only a Weak or lower Buy  rating.
Symbol and Exchange: BRKB, New York
Currency: $ U.S.
Contact: 0
Latest four quarters annual sales $ millions: $240,903.0
Latest four quarters annual earnings $ millions: $18,675.0
P/E ratio based on latest four quarters earnings: 24.6
Latest four quarters annual earnings, adjusted, $ millions: $15,501.0
BASIS OR SOURCE OF ADJUSTED EARNINGS: For valuation purposes we use 10% of book value to reflect its average annual book value per share gains. Graph uses operating earnings provided by management which excludes gains/losses on investments including derivatives. But it does not adjust for the lumpy results in the insurance business. Earnings may be under-stated due to the continuing deferral of significant income taxes and due to amortization of certain goodwill-like intangibles.
Quality of Earnings Measurement and Persistence: GAAP earnings are  under-stated because for an investment like Coke shares, in which it has a huge investment, its earnings reflect only dividends received and not its share of Coke’s earnings and not any gains or losses in market value of Coke. It’s adjusted earnings are understated for the same reason and because adjusted earnings remove all gains or losses on investments sold and yet in the vast majority of years these are positive. Also earnings reflect a 31% income tax when on a current tax payable they are closer to 20% due deferred taxes. Earnings are also volatile due to the volatile nature of insurance operations. While its GAAP and adjusted earnings ROEs seem to be low, its increase in book value per share has averaged 10.8% per year in the seven years ending 2016. Overall, the earnings quality and persistence is very good although volatile.
P/E ratio based on latest four quarters earnings, adjusted 29.6
Latest fiscal year annual earnings: $24,074.0
P/E ratio based on latest fiscal year earnings: 19.1
Fiscal earnings adjusted: $17,577.0
P/E ratio for fiscal earnings adjusted: 26.1
Latest four quarters profit as percent of sales 6.4%
Dividend Yield: 0.0%
Price / Sales Ratio 1.91
Price to (diluted) book value ratio:                                         1.49
Balance Sheet: (Updated for Q3, 2017) 16% of the assets are in cash and equivalent including treasury Bills. 24.5% of assets are in equity investments (of which 2.3 percentage points are Kraft Heinz) and an additional 4% is in fixed income and other investments. 2% is in mortgage loans receivable. Purchased goodwill represents 12% of assets. 23% of assets are in the property plant and equipment of its various businesses with the vast majority of that being in its utility and railroad businesses.  The remaining 18.5% is in receivables, inventory and other. These assets are financed 46% by equity, 21% by insurance liabilities. 15% by debt, about 12% by deferred income tax, 5% by accounts payable, and 1% by regulatory liabilities and a small derivative liability. This is a very strong balance sheet. The use of debt and insurance float liabilities is low compared to most “insurance” companies.
Quality of Net Assets and Book Value Measurement: With the shares trading at about 1.49 times book value, it is worthwhile to consider if the book value of the equity might be over- or under-stated. Under accounting rules the book value should be conservatively stated. However, many assets are marked to market. Insurance liabilities are intended to be conservatively stated but are subject to uncertainty. In Berkshire’s case these liabilities have provided investment funds at a cost of less than zero most years (there is an underwriting profit rather than the usual underwriting loss) and these funds regenerate annually. The many 100% owned operating companies likely have substantial additional goodwill value which is not recognised (except for the more recent acquisitions where the goodwill is already on the books due to the recent purchase). Overall the book value of assets is likely under-stated. Warren Buffett has indicated that intrinsic value is significantly higher than 120% of book value but it is not clear if that would exceed the 149% level. Buffett has indicated that the insurance liabilities of Berkshire (but not other insurance companies) can be considered to be  like equity since it is a growing source of money for investment that has been obtained at a negative “interest” cost due to the underwriting profits. See page 4 of the 2007 annual letter where he said the insurance investments could be considered an unencumbered source of value to investors if underwriting profits remain on average positive in the future, which he expected they would. We interpret that to mean that the “liability” of the float is a very soft liability, a less than zero cost liability and so somewhat equity like. Deferred income taxes are a liability that incurs no interest costs and also regenerates or grows each year and is therefore also a rather soft liability.
Number of Diluted common shares in millions:                              2,467.0
Controlling Shareholder: Warren Buffett, who is chairman and CEO, owns about 17% of the company and is the controlling shareholder.
Market Equity Capitalization (Value) $ millions: $459,377.1
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 45.2%
Interest-bearing debt as a percentage of common equity 33%
Current assets / current liabilities: not provided
Liquidity and capital structure: Berkshire has a rare AA credit rating and is self described as having Gibraltar-like financial strength.
Latest four quarters adjusted (if applicable) net income return on average equity: 5.4%
Latest fiscal year adjusted (if applicable) net income return on average equity: 6.5%
Adjusted (if applicable) latest four quarters return on market capitalization: 3.4%
5 years compounded growth in sales/share 9.3%
Volatility of sales growth per share:  Strong growth
5 Years compounded growth in earnings/share 18.7%
5 years compounded growth in adjusted earnings per share 10.4%
Volatility of earnings growth:  Volatile growth
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? Yes, although earnings are lumpy
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 6.5%
More conservative estimate of compounded growth in earnings per share over the forecast period: 7.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 10.0%
OUTLOOK FOR BUSINESS: The level of earnings in any given period is unpredictable.  It seems likely that Berkshire will continue to grow its size and earnings at an acceptable rate in the future. (However this would likely be in the range of  perhaps 10% per year and not the huge growth of bygone years) The ultimate death of Buffett would likely lead to lower investment results and to decreased acquisition opportunities. Berkshire is increasingly the acquirer of choice for large family-owned private corporations that wish to sell. Berkshire could see a large one-time boost from tax reform as its huge deferred tax liabilities could be reduced substantially. This could lead to an accounting gain in the order of $34 billion dollars which would boost book value per share by 11 percent. And, there would be ongoing benefits from the lower tax rate as well.
LONG TERM PREDICTABILITY: Berkshire is probably relatively predictable in the long term although any individual year can suffer from large insurance losses.
Estimated present value per share: Note that we have calculated adjusted earnings in an unusual way, that is by assuming its normalized earnings level is 10% of book value based on its achievement of an average total increase in book value per share of just under 10% per year on average in the past ten years. This brings its average gains on investments into the picture.  On that basis, We calculate  $166 if such adjusted earnings per share grow for 5 years at the more conservative rate of 7% and the shares can then be sold at a P/E of 13 and $235 if such adjusted earnings per share grow at the more optimistic rate of 10% for 5 years and the shares can then be sold at a P/E of 16. Both estimates use a 6.5% required rate of return. However, if we use 8% of book value the range drops to $133 to $188.
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) As a huge conglomerate it is difficult to assess the industry attractiveness. Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition based on the following four tests. No barriers to entry (Pass, Buffett looks to buy companies with barriers to entry). No issues with powerful suppliers (pass). No issues with dependence on powerful customers (pass – most of the Berkshire business serve a huge consumer base), No potential for substitute products (Pass, Buffett looks for companies that sell essential products) No tendency to compete ruinously on price (Pass, Buffett looks for companies that do not compete heavily on price).
COMPETITIVE ADVANTAGE: When it comes to large acquisitions of attractive privately owned companies, Berkshire/Buffett is clearly a (and probably THE) purchaser of choice. Any seller of a large private company knows that with Berkshire, his sold company would be in excellent hands. When it comes to large reinsurance transactions, Berkshire/Buffett is again very much a partner of choice. We have recently seen “bond insurers” fail. Customers of Berkshire would be confident that it would not fail to deliver on its obligations. Many of Berkshires operating companies have competitive advantages in terms of brand names and lower operating costs. Berkshire’s willingness to purchase either stocks or businesses doubles its investment horizons and is an advantage.
COMPETITIVE POSITION: It is very difficult to comment on its competitive position because it has so many operating companies. However, Buffett’s strategy has been to invest in companies with competitive advantages. GEICO has  the cost advantage of being a direct seller (no brokers). General RE and all of the insurance operations have the advantage of Berkshire’s excellent financial strength and trust. The utilities are not high profit but are generally regulated monopolies, the rail road may be the only choice for many of its customers. Many of its retail and manufacturing operations have low-cost advantages and strong brand equity, but some are not performing well and have no great advantages. The equity investments are chosen from companies with competitive advantages.
RECENT EVENTS: In Q3 2017, Berkshire has suffered substantial losses in its catastrophe insurance operations due to three hurricanes and an earthquake. This is to be expected periodically. Berkshire has also recently reported some insurance losses due to the fact that it underestimated certain losses in prior years. We believe that this is unusual for Berkshire and is a negative development.  Berkshire continues to make various acquisitions. In early October, Berkshire announced that it was acquiring 39% of Pilot Flying J a large truck-stop operator with $20 billion in annual revenues.  The latest major acquisition was the 2016 purchase of Precision Castparts for $32 billion. Also the purchase of Duracell in early 2016. Heinz, which had been 50% owned by Berkshire has purchased Kraft for stock and cash which left Berkshire owning 26% of the combined Kraft / Heinz. This transaction required Berkshire to recognise a very large non-cash gain on its ownership in Heinz.
ACCOUNTING AND DISCLOSURE ISSUES: Warren Buffett and Berkshire Hathaway are considered to be the “Gold Standard” regarding accounting and disclosure. Disclosure is very good. Nevertheless, this is a complex company consisting of about 200 operating companies. Its large portfolio of common shares causes its earnings to be understated. This is because for a company like Coke, of which it owns 9.3%, its earnings reflect only the dividend received from Coke and not its share of Coke’s earnings and not any change in the market value of this investment. The lumpy nature of gains and losses on investments makes earnings difficult to interpret. Even the revenue growth gets distorted because gains on investments are required to be treated as revenues. We would prefer it  would release a Q4 report as well as a year-end report. There is a significant amount of amortization of intangibles (approaching 1 billion annually) that we (and Buffett) do not consider to be a real expense because the value of those intangibles (trademarks an customer relationships purchased) is likely increasing.
COMMON SHARE STRUCTURE USED: The B shares are equivalent to 1/1500th of an A share except that they get only 1/10,000th of a vote.
MANAGEMENT QUALITY: Warren Buffett is widely acknowledged as one of the most able and trustworthy executives ever. He also indicates that he has a superb stable of managers for the operating companies and that successors for both his operating management and his investment duties are in the wings when needed.
Capital Allocation Skills: Berkshire’s capital allocation skills under Buffett’s leadership have been second to none. Berkshire has both a superior track record in capital allocation and superior opportunities compared to most companies. With a vast stable of companies and with a penchant for acquisitions of companies and/or marketable securities it is able to direct capital to the most attractive opportunities.
EXECUTIVE COMPENSATION: (Updated November 2017) At the holding company level, Berkshires compensation is minimal. Warren Buffett and his vice chairman, Charlie Munger take only $100,000 each in salary. The CFO is paid (only) $1.55 million per year (but presumably owns a significant number of shares). No stock options or any other material compensation is provided. The compensation of the executives of the operating companies is not directly disclosed, but we can be virtually certain that it would not be excessive though it may be high reflecting performance. In any case, given the size of this company, executive compensation is not an issue.
BOARD OF DIRECTORS: 11 directors , all with substantial ownership in the company. Buffett considers these people to possess excellent business judgment and to be people who will look after shareholders interests. They would not likely be considered very independent, given long-standing friendship with Buffett in most cases. However, Buffett has argued that most are independent by virtue of their wealth. He would expect them to be in a position to provide critical advice when needed.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, earnings growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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