What is the true P/E multiple for Berkshire Hathaway?

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 Coca-Cola (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 Coca-Cola (KO). If you consider those earnings, the stock trades at closer to 11-12 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 11-12 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?

Analyst:  Your intuition about dividend double-counting 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 Coca-Cola (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 held-for-trading or available-for-sale 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 20-50%, you use the Equity method. 

Now, can you re-calculate 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 per-share 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 per-share 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