Warren Buffett’s Calculation Of Berkshire Hathaway Stock Return

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Warren Buffett’s Calculation Of Berkshire Hathaway Stock Return
By Mark Hirschey (Work of Mark Hirschey) [CC BY-SA 2.0], via Wikimedia Commons

Why Does Warren Buffett Calculate His Return Based On The Book Value Of Berkshire Hathaway’s Stock Rather Than The Market Value? by S&C Messina

I would point to a few reasons.

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  1. One is that insurance companies trade relative to their book value on a price to book or P/B basis. With a lot of the book value of Berkshire coming from the aggregate book value of its insurance companies, it makes sense to measure and value Berkshire on the basis of its total book value. Much of Berkshire’s equity value is also created from utilizing its massive insurance “float”, which is another reason to look at Berkshire like an insurance company. Other businesses that manage assets and liabilities to create equity value, such as banks, also trade at a multiple of book value. You’ll see publicly-traded closed-end funds trade as a premium or discount to NAV or net asset value of the portfolio – NAV is the equivalent of book equity value; as Berkshire is a conglomerate of investment holdings, this makes it also similar to a publicly traded fund that trades at a premium or discount to its NAV.
  2. I would also say Warren Buffett is following the tradition of Benjamin Graham’s methodology of using book value as a conservative measure or “floor” or liquidation value of a company. One of the reasons Graham preaches this is because of the conservative nature of this valuation methodology, as it’s akin to the following:Say you put $200 of cash to start a company. So you have $200 of book equity that you own. If you use $200 to buy a manufacturing plant, then the cash disappears and you have $200 of PP&E as assets which is still matched by $200 of book equity. This totally ignores the future cash generating power of the manufacturing plant; if you sold the manufacturing plant tomorrow in a liquidation and got $200 for it, then you got your money back. But what if the manufacturing plant has been throwing off a stream of cash flows of $30 per year and will continue to do so forever? If you took the net present value or NPV of those future cash flows by saying the riskiness or discount rate of these annual perpetual cash flows is 10%, then the NPV will be $30/10% or $300, which is greater than the $200 in book value. That NPV is the market value, which should be trading at a premium to book value at $300/$200 or 1.5x price to book. Thus, purchasing the company at a liquidation or book value of $200 provides a significant margin of safety below the true economic value or NPV or market value of $300.
  3. Graham and Warren Buffett have often knocked on the accounting used by companies (i.e. today companies report using GAAP) when depicting earnings power, especially with regards to the income statement. Net income as reported by the income statement can be skewed by non-cash and non-recurring expenses that don’t truly reflect the true, recurring cash flow generation power of the company. In other words, earnings aren’t necessarily equivalent to actual cash flow. Theoretically, they should approximate each other in aggregate over time, but a lot of manipulation can occur. Furthermore, the income statement doesn’t really show the necessary, ongoing capital expenditures that are needed to maintain those recurring cash flows. Such maintenance capex is supposed to be approximated by D&A or depreciation, but depreciation can not only be a mix of growth capex and maintenance capex but also manipulated by management as a non-cash expense.Balance sheet items, however, are more static as they are a snapshot in time on one day at the end of a reporting period, as opposed to being a record of earnings over the duration of a reporting period. So in this way, balance sheet items are somewhat less subject to manipulation – it is what it is on that day. Having said that, accounting on the balance sheet can still often skew true economic value with items such as goodwill and other intangible assets that are subject to misestimation and biased measurement by accountants or management. You’ll see insurance companies often report TBV or tangible book value, which removes non-tangible assets or adds back a liability that should not have been deducted. While balance sheet items can also be subject to manipulation by companies who will move assets or liabilities around a few days before the end of the reporting period to make the balance sheet look better, manipulation on the income statement might be easier and more tempting to do. Stocks and market caps often rise and fall significantly based on barely beating or missing revenue and EPS estimates, not because of line items on the balance sheet. (Though, if a company is in financial distress or a liquidity crisis, balance sheet results can have a massive impact on the stock.)

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  1. Benjamin Graham – also known as The Dean of Wall Street and The Father of Value Investing – was a scholar and financial analyst who mentored legendary investors such as Warren Buffett, William J. Ruane, Irving Kahn and Walter J. Schloss.

    Buffett describes Graham’s book – The Intelligent Investor – as “by far the best book about investing ever written” (in its preface).

    Graham’s first recommended strategy – for casual investors – was to invest in Index stocks.
    For more serious investors, Graham recommended three different categories of stocks – Defensive, Enterprising and NCAV – and 17 qualitative and quantitative rules for identifying them.
    For advanced investors, Graham described various “special situations”.

    The first requires almost no analysis, and is easily accomplished today with a good S&P500 Index fund.
    The last requires more than the average level of ability and experience. Such stocks are also not amenable to impartial algorithmic analysis, and require a case-specific approach.

    But Defensive, Enterprising and NCAV stocks can be reliably detected by today’s data-mining software, and offer a great avenue for accurate automated analysis and profitable investment.

    For example, given below are the actual Graham ratings for Bank of America Corporation (BAC), with no adjustments other than those for inflation.

    Defensive Graham investment requires that all ratings be 100% or more.
    Enterprising Graham investment requires minimum ratings of – N/A, 75%, 90%, 50%, 5%, N/A and 137%.

    Bank of America Corporation – Graham Ratings
    Sales | Size (100% ? $500 Million): 16,394.40%
    Current Assets ÷ [2 x Current Liabilities]: 2.09%
    Net Current Assets ÷ Long Term Debt: 0.00%
    Earnings Stability (100% ? 10 Years): 40.00%
    Dividend Record (100% ? 20 Years): 100.00%
    Earnings Growth (100% ? 30% Growth): 9.91%
    Graham Number ÷ Previous Close: 7.27%

    Not all stocks failing Graham’s rules are necessarily bad investments. They may fall under “special situations”. Graham’s rules are also extremely selective.

    Warren Buffett once wrote a detailed article explaining how Graham’s record of creating exceptional investors (such as Buffett himself) is unquestionable, and how Graham’s principles are everlasting. The article is called “The Superinvestors of Graham-and-Doddsville”.

    Thank you.

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