Berkshire Hathaway (BRK) is a
longterm holding of two good friends: one a smart and successful investor, the
other an analyst. They recently read an
interview in Barron’s where the fund manager (De Lardemelle) stated that BRK’s earnings did not
fully reflect the earnings of its equity investment in other companies,
including CocaCola (KO) (Barron’s
magazine, August 11, 2012, Ways to play American exceptionalism) (Ways
to play American exceptionalism ).
Below is the excerpt
from Barron’s:
Questioner: By our calculations, the stock is trading at around 15 times next year's profit estimate of $8,265 a share.
De Lardemelle: What that is not catching is the earnings on their equity portfolio, including CocaCola (KO). If you consider those earnings, the stock trades at closer to 1112 times. What I also like about Berkshire Hathaway is that if there is a downturn in the equity markets, it usually allows it to grow its intrinsic value faster as they put more money to work. It is very unusual to have a business that grows in value as the economy or the stock market falls sharply.
Below is the dialog
between the investor and the analyst on BRK’s PE multiple issues:
Investor: I think the 1112 is a little aggressive. Also,
since dividends
received by Berkshire are counted in earnings, there is some double counting going on. Therefore, my best
guess is that the true multiple on next
year's earnings is 13.
There you have it. 13.
It is possible that I am the only one on the planet who knows the P/E multiple. But can we be sure?
There you have it. 13.
It is possible that I am the only one on the planet who knows the P/E multiple. But can we be sure?
Analyst: Your intuition about dividend doublecounting
is right. It needs to be subtracted when using Equity method accounting (see
below). De Lardemelle is also right in his claims. Here is
where the issue needs to be clarified. It has to do with accounting
method used in reporting the investment. (I happened to learn this in CFA
level II). Let's use CocaCola
(KO) as an example.
BRK is currently reporting its equity investment as "
Investment in financial assets". Using this method, it will report
dividend received from KO and realized gain/loss in its Income Statement.
In Balance sheet, it will report KO's current stock value.
(Unrealized gain/loss is also reported, in either Income Statement or Other
Comprehensive Incomes depending on whether it is a heldfortrading or
availableforsale securities.).
Now, if BRK would use Equity method to report KO holding,
then it will report % ownership of KO Earnings in its Income Statement, whereas
in its Balance sheet, it will report initial investment cost+%ownership of KO
Retained Earnings (after dividend payout).
The guideline is that for investment <20% ownership, you
treat it as " Investment in financial assets" For
2050%, you use the Equity method.
Now, can you recalculate P/E for BRK, using the Equity
method?
Investor: Your approach is too long.
The multiple is 13.
Stay long. Low Beta. B+ management. A++ on tax efficiency.
Analyst: An analyst is fixated on getting
accurate numbers, whereas a smart, intuitive, (but impatient) investor just
wants bulk park estimates that are good enough to guide his/her investment
decision, then MOVE ON.....
So, what are the earnings and P/E
multiples for BRK if it would include the percentage of earnings from its
equity investments?
We compute these numbers in the
Table below, using actual data from BRK’s 2011 10K and estimated earnings from
Bloomberg (Reference: BRK 2011 10K filing; Bloomberg
BRK/A:US).
(a) 2011
numbers are obtained from BRK 2011 10K.
(b) According
to Bloomberg, BRK’s 2012 and 2013
profit estimates per share are $7912 and $8265. From these pershare earnings estimates, we
derive estimated total earnings of $19,363 and $20,194 for 2012 and 2013,
respectively.
(c) The
equity investment interest and dividend in 2011 was $1618 (see Revenue, Finance
and Financial products, p.66). This includes interest and dividend payments
from its investment in banks, insurance companies, consumer products,
commercial, industrial companies (p.78).
This number does not include the preferred dividends from its
investments in Goldman Sachs, GE, Wigley, Dow, and Bank of America. These preferred dividends are shown as Other
Investment (p.79, p66).
(d) We
assume that the interest and dividend income will grow 5% annually, thus
obtaining the $1700 and &1784 estimates for 2012 and 2013.
(e) If BRK would use Equity method to account for
its ownership in those equity portfolio companies, then it will report %
earning instead of dividend. Assuming
these companies have 40% dividend payout ratio, its earnings from equity
investment attributable to BRK will be $4460.
To summarize, BRK’s 2013 P/E is 15.39x based on current
accounting method. However, if BRK would
use Equity method to account for its equity portfolio investment, then the P/E
would be 12.45x. Given some margin of
safety, the Investor’s number is closer to the estimate.
Disclosure: We are
long BRK.
Table 1: Calculation of BRK P/E multiples
(dollars in millions, except pershare amounts) (E:
estimates from Bloomberg
BRK/A:US) (Reference: BRK 2011 10K filing; Bloomberg
BRK/A:US).

2011

2012

2013
Financial
assets method

2013
Equity
method

Interest,
Dividend, other investment

1,618

1,700 (estimate)

1,784
(estimate)

0

Earnings
before tax

15,314

19,363 (E)

20,194 (E)

18,410 (E)

Tax (30%)

4,568

5,809 (E)

6,058 (E)

5,523 (E)

Net
earnings

10,746

13,554 (E)

14,136 (E)

12,887 (E)

Minority
interest

500

500

500

500

Net
earnings to BRK

10,254

13,053 (E)

13,636 (E)

12,387 (E)

Earnings
from equity method investment

0

0

0

4,460

Net
earnings (total)

10,254

13,053 (E)

13,636 (E)

16,847 (E)

Shares
outstanding

1,649,891

1,649,891

1,649,891

1,649,891

EPS

6,215

7,912 (E)

8,265 (E)

10,211 (E)

Stock
price (as of 8/10/2012)


$127,175



P/E
multiple

20.46 x

16.07 x

15.39 x

12.45 x
