Investment Thesis Berkshire Hathaway is a holding company headquartered in Omaha, Nebraska. Berkshire’s subsidiaries engage in various lines of business including property and casualty insurance and reinsurance, utilities and energy, finance, manufacturing, services, and retailing. Berkshire has consistently demonstrated an ability to generate exceptional returns on capital. In addition, the company has thrived in prior periods of economic turmoil and has created tremendous value for its shareholders as a result. Berkshire’s constant focus on prudent capital allocation and acquiring businesses that possess sustainable competitive advantages will allow the company to prosper for decades to come. When shares of this type of company are trading at a discount to intrinsic value, as Berkshire’s shares currently are, it is a tremendous opportunity for the long-term investor to purchase a stake in a company that will generate a consistent and reasonable return for decades to come.
Summary Berkshire Hathaway’s strengths include:
• $35.6 billion in cash that will allow the company to capitalize on opportunities presented by the current economic climate.
• Minimal leverage, a AAA credit rating, and consistent generation of sizeable free cash flow.
• Zero “Buffett premium” built into the current price, and potentially even a “Buffett discount.”
• The opportunity to capitalize on the eventual turnarounds of the financial and housing sectors without assuming the risks associated with pure-play companies in these sectors.
NYSE: BRKA
Recommendation: Buy
Current Price: $123,970 Target Price: $145,000
Analyst Information:
Analyst: Nate Palmer
Fisher College of Business
The Ohio State University
Columbus, Ohio
Contact: 614.599.6017
E-mail: [email protected]
Updated: May 26, 2008
Fund: OSU SIM (BUS FIN 824)
Manager: Royce West, CFA
Stock Information:
Sector: Financial
Industry: Insurance
Market Cap: $192.004 billion
Shares Outstanding:1.5 million
52 Week High: $151,650
52 Week Low: $107,200
YTD Return: -12.45%
Beta: 0.30
Berkshire Hathaway Inc.
Earnings Per ShareIn dollars per share
$2,795
$5,309
$4,753
$5,538
$7,144
$8,548
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
$9,000
2002 2003 2004 2005 2006 2007
2
Table of Contents1
Investment Thesis……………………………………………………………………………………….…1 Summary…………………………………………………………………………………………………...1 Company Overview………………………………………………………………………………………..3 Macroeconomic Analysis and Outlook…………………………………………………………………....4 Financial Sector Analysis and Outlook……………………………………………………………………5 Financial Sector Valuation………………………………………………………………………………...6 Berkshire Relative to Financial Sector…………………………………………………………………….7 Berkshire Absolute Valuation……………………………………………………………………………..8 How Buffett Values Berkshire…………………………………………………………………………….8 Investment Portfolio……………………………………………………………………………………….9 Operating Businesses……………………………………………………………………………………..10 Comparative Analysis: Berkshire Relative to Conglomerates…………………………………………....12 Comparative Analysis: Berkshire Relative to Insurers………………………………………………...…13 Discounted Cash Flow Analysis………………………………………………………………………….14 Income Statement Projection……………………………………………………………………………..14 Discounted Cash Flow Model………………………………………………………………………….....14 Risks and Concerns……………………………………………………………………………………….15 Key Manager Risk .. …………………………………………………………………………….………..15 Insurance Industry……………………………………………………………………………...…………16 Derivatives………………………………………………………………………………………....…...…17 Conclusions………………………………………………………………………………………………..17 Appendix 1: Berkshire Hathaway Financial Statements from Company10-K…………………….……...19 Appendix 2: Berkshire Hathaway Income Statement Forecast and Discounted Cash Flow Model………22
1 Data in all absolute and relative valuation tables was provided by StockVal
3
Company Overview2
Headquartered in Omaha, Nebraska, Berkshire Hathaway Inc. is a holding company owning
subsidiaries that engage in a number of diverse business activities including property and casualty
insurance and reinsurance, utilities and energy, finance, manufacturing, services, and retailing. Included
in the group of subsidiaries that underwrite property and casualty insurance and reinsurance is GEICO,
one of the four largest auto insurers in the United States. This group also includes two of the largest
reinsurers in the world, General Re and the Berkshire Hathaway Reinsurance Group. Other subsidiaries
that underwrite property and casualty insurance include National Indemnity Company, Medical Protective
Company, Applied Underwriters, U.S. Liability Insurance Company, Central States Indemnity Company,
Kansas Bankers Surety, Cypress Insurance Company, BoatU.S., and several other subsidiaries referred to
as the “Homestate Companies.”
MidAmerican Energy Holdings Company (“MidAmerican”) is an international energy holding
company owning a wide variety of operating companies engaged in the generation, transmission and
distribution of energy. Among MidAmerican’s operating energy companies are Northern Electric,
Yorkshire Electricity, MidAmerican Energy Company, Pacific Power, Rocky Mountain Power, Kern
River Gas Transmission Company, and Northern Natural Gas. In addition, MidAmerican owns
HomeServices of America, a real estate brokerage firm. Berkshire’s finance and financial products
businesses primarily engage in proprietary investing strategies (BH Finance), commercial and consumer
lending (Berkshire Hathaway Credit Corporation and Clayton Homes), and transportation equipment and
furniture leasing (XTRA and CORT). Shaw Industries is the world’s largest manufacturer of tufted
broadloom carpet. McLane Company is a wholesale distributor of groceries and nonfood items to
convenience stores, wholesale clubs, mass merchandisers, quick service restaurants and others.
Numerous business activities are conducted through Berkshire’s other manufacturing, service,
and retailing subsidiaries. Benjamin Moore is a formulator, manufacturer, and retailer of architectural
and industrial coatings. Johns Manville is a leading manufacturer of insulation and building products.
Acme Building Brands is a manufacturer of face brick and concrete masonry products. MiTek Inc.
produces steel connector products and engineering software for the building components market. Fruit of
the Loom, Russell, Vanity Fair, Garan, Fechheimer, H.H. Brown Shoe Group, and Justin Brands
manufacture, license, and distribute apparel and footwear under a variety of brand names. FlightSafety
International provides training to aircraft and ship operators. NetJets provides fractional ownership
programs for general aviation aircrafts. Nebraska Furniture Mart, R.C. Willey Home Furnishings, Star
Furniture, and Jordan’s Furniture are retailers of home furnishings. Borsheims, Helzberg Diamond
Shops, and Ben Bridge Jeweler are retailers of fine jewelry.
2 Adapted from Berkshire Hathaway 2007 10-K
4
In addition, other manufacturing, service and retail businesses include: Buffalo News, a publisher
of a daily and Sunday newspaper; See’s Candies, a manufacturer and seller of boxed chocolates and other
confectionery products; Scott Fetzer, a diversified manufacturer and distributor of commercial and
industrial products, the principal products of which are sold under the Kirby and Campbell Hausfeld
brand names; Albecca, a designer, manufacturer, and distributor of high-quality picture framing products;
CTB International, a manufacturer of equipment for the livestock and agricultural industries; International
Dairy Queen, a licensor and service provider to approximately 6,000 stores that offer prepared dairy treats
and food; The Pampered Chef, the premier direct seller of kitchen tools in the U.S.; Forest River, a
leading manufacturer of leisure vehicles in the U.S.; Business Wire, the leading global distributor of
corporate news, multimedia, and regulatory filings; Iscar Metalworking Companies, an industry leader in
the metal cutting tools business; TTI, Inc., a leading distributor of electronic components, and Richline
Group, a leading jewelry manufacturer.
Operating decisions for the various Berkshire businesses are made by managers of the business
units. Investment decisions and all other capital allocation decisions are made for Berkshire and its
subsidiaries by Warren E. Buffett, in consultation with Charles T. Munger. Mr. Buffett is Chairman and
Mr. Munger is Vice Chairman of Berkshire’s Board of Directors.
Macroeconomic Analysis and Outlook
The macroeconomic outlook for 2008 has weakened significantly in the past 6 months as the
effects of the global credit crunch and current housing crisis are being felt throughout the entire domestic
and global economy. Although a recession seems eminent, consensus seems to be that the recession will
be relatively short and shallow in nature. I disagree with the consensus and believe that the recession will
be both longer and more severe than consensus estimates. Both George Soros and Warren Buffett, two of
the greatest macroeconomic minds of their generation, are on record saying that they believe the recession
will be longer and deeper than most people are currently forecasting. Soros has even called this “the
worst economic crisis in 75 years.”3 I agree with these individuals that the collapse of housing prices in
combination with the large-scale contraction in lending will prove detrimental to the overall economy in
2008. I currently forecast single digit negative GDP growth in 2008. Because this outlook is
significantly below the consensus, if it materializes, there could be sizeable declines in stock prices as
investors adjust their expectations.
Macroeconomic Impact on Berkshire Hathaway
Because Berkshire Hathaway’s operating businesses and investment portfolio are diversified over
numerous industries and lines of business, the risk of a downturn in any single sector of the economy
3 Schurenberg, Eric. "Big-Picture Guy." Money June 2008: 114.
5
having a major impact on Berkshire is minimal. Due to its size and diversification, Berkshire is a
defensive play for most investors. Nonetheless, Berkshire has significant exposure to both the financial
and housing sectors. With 2007 earnings per share of $8,548, a 19.7% increase from 2006 EPS, it would
seem that Berkshire was running on all cylinders. However, as detailed in the Company Overview above,
the performance of several of Berkshire’s operating businesses is directly tied to the housing sector.
Acme Brick Co., Clayton Homes, Jordan’s Furniture, RC Wiley Home Furnishings, Shaw Industries, and
Star Furniture were all adversely affected in 2007 by the downturn in the housing sector. In addition,
Berkshire’s investment portfolio was hurt by significant exposure to financials as well as slight exposure
to the housing sector. The market value of investments in American Express, Moody’s Corporation, U.S.
Bancorp, and Wells Fargo declined notably as a result of the current credit situation. In addition, the
market value of Berkshire’s investment in USG, which manufactures and distributes building materials
and gypsum wallboard, declined significantly due to the lack of new construction in the homebuilding
industry. So although Berkshire posted strong earnings figures in 2007, this was despite the struggles of
its businesses and investments related to the housing and financial sectors. When economic conditions
improve, it is reasonable to assume that these businesses will be able to revert to normalized earnings, and
Berkshire’s bottom line will benefit further. Thus, although its sector diversification prevented Berkshire
from being as adversely affected by the current housing and credit situation as many of its competitors,
the company will still realize substantial benefit from the eventual turnaround in the housing and financial
sectors.
Financial Sector Analysis and Outlook The financial sector is in the mature phase of the life cycle, but will continue to grow with the
overall economy since financial institutions serve as the major source of capital for economic expansion.
As the figure to the right4 illustrates, financials perform best late in bear markets and early in bull
markets. Thus, there is significant upside in financials when the current economic downturn begins to
subside, but in order to profit in the sector, investors
may need to be patient.
The financial sector was severely battered in
2007, and the carnage has continued thus far in
2008. While the sector as a whole has rebounded
slightly from its trough earlier in 2008, significant
pessimism remains. Although bargains do exist in
4 Stovall, Sam. The S&P Guide to Sector Investing.
New York: McGraw Hill, 1995.
6
the sector, it is also full of value traps. Recent capital infusions at
Washington Mutual, National City, Wachovia, and others have illustrated
how quickly shareholders can be diluted when financial institutions are
desperate to raise capital. In addition, the near-collapse of Bear Stearns
illustrated the inherent danger of highly leveraged financial institutions.
Further write-downs at many financial institutions may pose the risk of insolvency, which carries with it
the potential that existing equity holders could be completely wiped out.
Due to the risk of financials in the current economic environment, this sector as a whole is not for
the short-term investor or overly risk averse investor. However, careful selection of financial institutions
that were fearful while their peers were greedy and are now poised to be greedy while others are fearful,
could produce significant returns for the long-term oriented investor. Nonetheless, investors in financials
must realize that if economic conditions continue to worsen, things could get worse in the financial sector
before they get better.
Financial Sector Valuation
On an absolute basis, despite appearing to be fairly valued in comparison to the multiples at
which the sector has traded over the past 10 years, financials may in fact be undervalued. Because the
earnings of financial institutions are currently at cyclical lows due to the recent write-downs in the sector,
Return
Difference
Relative to
S&P500
YTD -16.05% -9.76%
2007 -20.82% -24.35%
2006 17.02% +3.41%
2005 5.12% +2.12%
Financial Sector Returns
High Low Mean Current
Percent From
Mean
Forward PE 24.40 10.30 14.20 13.20 -7.0%
Trailing PE 21.60 10.50 14.30 15.90 11.2%
Price to EBITDA 4.50 2.20 3.50 2.50 -28.6%
Price to Sales 29.50 13.76 20.09 18.92 -5.8%
Price to Book 3.40 1.30 2.10 1.30 -38.1%
Price to Cash Flow 14.20 9.20 11.80 12.60 6.8%
PEG Ratio 1.40 0.80 1.10 1.20 9.1%
Return on Equity 19.20 8.30 15.90 8.30 -47.8%
Financial Sector Valuation - Absolute - 10 years
High Low Mean Current
Percent From
Mean
Forward PE 1.35 0.52 0.71 0.91 28.2%
Trailing PE 1.05 0.49 0.71 0.96 35.2%
Price to EBITDA 0.64 0.38 0.51 0.40 -21.6%
Price to Sales 19.07 6.67 11.64 14.58 25.3%
Price to Book 0.77 0.48 0.69 0.50 -27.5%
Price to Cash Flow 1.28 0.79 1.01 1.17 15.8%
PEG Ratio 1.09 0.68 0.85 1.01 18.8%
Return on Equity 1.11 0.52 0.93 0.52 -44.1%
Financial Sector Valuation - Relative to S&P 500 - 10 years
7
as earnings revert to the mean, the current multiples will likely appear cheap. The challenge for investors
is determining how long it will take for earnings in the financial sector to revert to the mean. The three
metrics that stand out in the absolute valuation are the price to EBITDA multiple, the price to book
multiple, and return on equity. All three of these metrics are impacted by the recent write-downs that
financial institutions have been forced to take. Because of the applicable accounting principles for
financial institutions, EBITDA excludes write-downs at most of these institutions. Therefore, current
price to EBITDA multiples are artificially low for institutions that have been burdened by major write-
downs in recent quarters since EBITDA excludes these write-downs (and thus EBITDA is artificially
high). The seemingly low price to book value multiple is also a function of write-downs in the financial
sector. In anticipation of future write-downs, investors have discounted book value and are willing to pay
a much lower multiple to stated book values because of the high probability that many financial
institutions will be forced to take additional write-downs. Finally, the low return on equity is a direct
result of write-downs as well. Write-downs have decimated net income for financial institutions, and
therefore return on equity is unusually low. Over the long-term, it is reasonable to expect net income and
return on equity to revert to the mean in the financial sector as economic conditions improve and these
institutions are able to move past the effects of the sub-prime lending crisis. Because of the unusually
low current net income figures at financial institutions as a result of write-downs, the financial sector will
likely prove to be relatively cheap despite current multiples seeming to indicate that it is fairly valued.
Relative to the S&P 500, financials appear to be expensive on the basis of price to forward and
trailing earnings, but this is the result of write-downs as discussed previously. Because many of these
write-downs are non-recurring items, financials again appear cheap on the basis of price to EBITDA. The
price to book ratio also indicates that financials may be cheap, but this is largely the result of investor
anticipation of future write-downs. Although the current turmoil in the financial sector makes it difficult
to definitively determine whether the sector is cheap relative to the S&P 500, it is apparent that there is
significantly more uncertainty in the financial sector than in the overall market. Investors will have to
determine whether the discounts in the sector are sufficient compensation for bearing the additional risk
associated with financials.
Berkshire Relative to Financial Sector
High Low Mean Current
Percent From
Mean
Forward PE 6.24 0.75 1.98 1.64 -17.2%
Trailing PE 4.76 1.13 2.09 1.29 -38.3%
Price to EBITDA 4.12 1.69 2.51 3.89 55.0%
Price to Sales 0.47 0.05 0.13 0.09 -30.8%
Price to Book 1.32 0.41 0.76 1.21 59.2%
Price to Cash Flow 1.95 1.17 1.45 1.29 -11.0%
PEG Ratio 99.90 1.05 1.45 1.17 -19.3%
Return on Equity 0.95 0.11 0.38 0.95 150.0%
BRKA Relative to Financial Sector - 10 years
8
Although multiples in the financial sector are distorted by recent and anticipated future write-
downs as addressed previously, Berkshire appears cheap relative to financials based upon several metrics.
Forward earnings, trailing earnings, sales, cash flow, and the PEG ratio all indicate that Berkshire is cheap
relative to the financial sector. However, Berkshire appears expensive relative to the sector on the basis
of EBITDA and book value. Despite the lack of a consensus valuation for Berkshire relative to the
financial sector, because a majority of the fundamental multiples indicate that it is cheap relative to the
sector, it is reasonable to conclude that Berkshire is currently trading at a discount to its historical
multiples relative to the financial sector.
Berkshire Absolute Valuation
Absolute valuation of Berkshire Hathaway produces a relatively wide range of target prices.
While the forward PE ratio, trailing PE ratio, and the price to sales ratio indicate that Berkshire is
significantly undervalued, the price to book and price to cash flow ratios indicate that it is fairly valued.
Finally, the price to EBITDA ratio indicates that Berkshire is overvalued at its current price. Overall, it
appears that Berkshire may be undervalued on an absolute basis, and at worst, it is fairly valued. The
forward PE multiple, trailing PE multiple, and price to sales ratios all produce target prices that are above
my target price of $145,000. However, since none of the historical multiple-based valuation methods
provide a definitive valuation for Berkshire, it is necessary to examine other valuation methods to
establish a framework within which the target price of $145,000 can be evaluated.
How Buffett Values Berkshire
Berkshire’s 1997 10-K provides the following guidance on valuation: “In our last two annual
reports, we furnished you a table that Charlie and I believe is central to estimating Berkshire’s intrinsic
value…In effect, the columns show what Berkshire would look like were it split into two parts, with one
entity holding our investments and the other operating all of our businesses and bearing all corporate
costs.” Berkshire’s investments per share and pre-tax earnings per share excluding all investment income
are displayed to the right. Since 1993,
Year Investments Per Share
Pre-Tax Earnings Per Share
Excluding All Investment Income
2007 $90,343 $4,093
High Low Mean Current
Normalized
Multiple
Current
Metric Per
Share Implied Target Price
Forward PE 99.9 13.0 26.5 21.7 26 5,713 $148,535.48
Trailing PE 82.5 15.6 27.7 20.5 27 6,047 $163,277.56
Price to EBITDA 10.6 7.3 9.0 9.9 9 12,522 $112,700.00
Price to Sales 8.5 1.5 2.4 1.8 2.3 69,646 $160,185.96
Price to Book 2.9 1.1 1.6 1.6 1.6 77,481 $123,970.00
Price to Cash Flow 20.0 13.8 16.7 16.3 16.7 7,606 $127,012.21
BRKA Fundamental Multiple-Based Valuation - 10 years
9
applying a 13 multiple to the pre-tax earnings per share generated by the operating businesses and adding
this figure to investments per share has provided a reliable approximation of Berkshire’s intrinsic value.
This valuation method provides an intrinsic value of $143,552 per share based on figures provided in the
2007 10-K. This target price is 15.6% above the May 23, 2008 closing price, and is very close to my
target price of $145,000. While this would seem to imply a reasonable margin of safety at the current
market price, examination of Berkshire’s investment portfolio and its collection of operating businesses is
necessary to affirm that this valuation method does provide a reasonable proxy for intrinsic value.
Investment Portfolio
Since 1964, Berkshire has constantly sought to build and grow an equity portfolio of publicly-
traded businesses that possess “wide moats” and are selling at a discount to intrinsic value at the time of
purchase. A business with a “wide moat” is one that possesses a sustainable competitive advantage that
will endure both economic and
societal changes. This competitive
advantage allows these businesses to
generate abnormally high returns on
capital, and thus should consistently
provide reasonable returns to
shareholders over the long-term if the shares can be purchased at a reasonable price. However, by
purchasing shares in these businesses when they are selling at a discount to intrinsic value, Berkshire has
been able to generate exceptionally high returns in its equity portfolio. Because emphasis is placed on the
long-term sustainability of the business’ competitive advantage, Berkshire often intends to hold these
shares forever, leading to
the mantra that the
company’s “favorite time
to sell is never.” The free
cash flow provided by
Berkshire’s operating
businesses, coupled with
the float provided by its
insurance businesses, has
served as a constant
source of capital for new
equity investments in the
investment portfolio. The
Shares Company
Percentage of
Company Owned
Cost
(in millions)
Market Value as
of 12/31/07 (in
millions)
151,610,700 American Express Company 13.10% $1,287 $7,887
35,563,200 Anheuser-Busch Companies, Inc. 4.80% $1,718 $1,861
60,828,818 Burlington Northern Santa Fe 17.50% $4,731 $5,063
200,000,000 The Coca-Cola Company 8.60% $1,299 $12,274
17,508,700 Conoco Phillips 1.10% $1,039 $1,546
64,271,948 Johnson & Johnson 2.20% $3,943 $4,287
124,393,800 Kraft Foods Inc. 8.10% $4,152 $4,059
48,000,000 Moody's Corporation 19.10% $499 $1,714
3,486,006 POSCO 4.50% $572 $2,136
101,472,000 The Procter & Gamble Company 3.30% $1,030 $7,450
17,170,953 Sanofi-Aventis 1.30% $1,466 $1,575
227,307,000 Tesco plc 2.90% $1,326 $2,156
75,176,026 U.S. Bancorp 4.40% $2,417 $2,386
17,072,192 USG Corp 17.20% $536 $611
19,944,300 Wal-Mart Stores, Inc. 0.50% $942 $948
1,727,765 The Washington Post Company 18.20% $11 1,367
303,407,068 Wells Fargo & Company 9.20% $6,677 $9,160
17,242,000 White Mountains Insurance Group Ltd. 16.30% $369 $886
Others $5,238 $7,633
Total Common Stocks $39,252 $74,999
Berkshire Hathaway Investment Portfolio - 12/31/2007
Year Per Share Investments Years
Compound Annual
Gain in Per Share
Investments
1965 $4
1979 $577 1965 - 1979 42.8%
1993 $13,961 1979 - 1993 25.6
2007 $90,343 1993 - 2007 14.3%
Investments per Share Over Time - 1965 - 2007
10
current market value of the common stock held in Berkshire’s investment portfolio is $74.999 billion.
Although the size of Berkshire has limited the company’s investment universe to primarily other
large-capitalization companies, Berkshire has consistently exhibited the ability to generate above-market
returns in the portfolio. Over the period from 1993 to 2007, the portfolio grew at a rate of 14.3% per
year, which surpassed the return of every major index over that period. So while Berkshire’s current size
will almost certainly prevent it from ever repeating the 42.8% annualized growth of the investment
portfolio that was generated from 1965 to 1979, it is not unreasonable to expect at least market returns
from the portfolio, and recent history would seem to indicate that market outperformance is a very
realistic expectation. The notion that Berkshire is too big to grow its investment portfolio at an above-
market rate certainly has not held true over the past 15 years. At a minimum, the portfolio will almost
assuredly generate steady returns over the long-term regardless of economic conditions.
Operating Businesses
As Berkshire has grown, so has the importance of its collection of operating businesses. While
Berkshire’s size now prevents it from taking meaningful partial stakes in small-capitalization and most
mid-capitalization companies, it can acquire entire small and mid-size businesses, in addition to large
businesses. In acquiring entire
businesses, Berkshire seeks the
same type of “moat” that it seeks
in its investment portfolio.
Although it is much more difficult
to acquire an entire business at a
deep-discount price than it is to acquire a portion of a business at this type of price, Berkshire has
consistently demonstrated the ability to identify businesses that possess sustainable competitive
advantages and has been able to acquire these businesses at a reasonable price.
For many Berkshire subsidiaries, the sustainable competitive advantage amounts to a combination
of a brand name that
promises quality,
coupled with a price
that is the best for that
level of quality.
Nebraska Furniture
Mart serves as a prime
example of how it and
many other Berkshire
Year
Per Share Pre-Tax
Earnings Years
Compound Annual
Gain in Per Share
Pre-Tax Earnings
1965 $4
1979 $18 1965 - 1979 11.1%
1993 $212 1979 - 1993 19.1%
2007 $4,093 1993 - 2007 23.5%
Operating Businesses Over Time - 1965 - 2007
Distribution of 2007 Non-Insurance Earnings
McLane
3%
MidAmerican
27%
Financial
15%Other Services
14%
Other
Manufacturing
31% Retail
4%
Shaw
6%
Financial
McLane
MidAmerican
Shaw
Retail
Other Manufacturing
Other Services
11
subsidiaries are able to prosper in both favorable and unfavorable
economic conditions. During favorable economic periods, their customer
base has a sizeable amount of discretionary income and purchases luxury
items and high-end electronics for their homes. Price is not as much of a
concern for many customers during these periods, and high-end and high
margin products are quite popular. During unfavorable economic periods,
price becomes more of a concern, and customers are attracted to Nebraska
Furniture Mart for the value lines of furniture carried in the store. In
addition to the usual customer base, the stores thrive during economic
downturns by attracting customers from other furniture and electronic
chains that cannot compete with the prices offered on Nebraska Furniture
Mart’s value lines. The ability to appeal to customers in all economic
conditions allowed Nebraska Furniture Mart to have a record year in 2007
while many of its competitors struggled mightily. Management has
indicated that both sales and margins have remained strong at the chain
thus far in 2008.
Prudent capital allocation among the operating businesses has
served as another source of competitive advantage for Berkshire’s
operating businesses. Each of the businesses retains cash needed to operate
and expand the business, but excess capital is returned to Omaha to be
strategically allocated by Buffett and Munger. This emphasis on putting
excess capital to use in the most effective manner has been one significant
factor in Berkshire’s ability to continue to generate high returns on capital
despite its enormous size.
A final source of competitive advantage for Berkshire with respect
to its operating businesses is that Berkshire is the buyer of choice for
certain privately held businesses. It is well documented that Berkshire
does not become involved in bidding wars when acquiring an operating
business because of the company’s focus on never overpaying. While this
does limit the company’s universe of acquisition candidates, it also ensures
that Berkshire only acquires operating businesses at what it judges to be a
reasonable price. The culture of Berkshire makes it the ideal acquirer for
many privately held or family owned businesses when the founder wants to
ensure that his or her business thrives into the future. The seller has the
Berkshire Hathaway Operating
Businesses
- Acme Brick Company
- Applied Underwriters
- Ben Bridge Jeweler
- Benjamin Moore & Co.
- Berkshire Hathaway Group
- Berkshire Hathaway Homestates
Companies
- BoatU.S.
- Borsheims Fine Jewelry
- Buffalo NEWS, Buffalo NY
- Business Wire
- Central States Indemnity Co.
- Clayton Homes
- CORT Business Services
- CTB Inc.
- Fechheimer Brothers Co.
- FlightSafety
- Forest River
- Fruit of the Loom
- Garan Incorporated
- Gateway Underwriters Agency
- GEICO Auto Insurance
- General Re
- Helzberg Diamonds
- H.H. Brown Shoe Group- HomeServices of America, a
subsidiary of MidAmerican Energy
Holdings Company
- International Dairy Queen, Inc.
- Iscar Metalworking Co.
- Johns Manville
- Jordan's Furniture
- Justin Brands
- Larson-Juhl
- Marmon Holdings, Inc.
- McLane Company
- Medical Protective
- MidAmerican Energy Holdings Co.
- MiTek Inc.
- National Indemnity Company
- Nebraska Furniture Mart
- NetJets
- The Pampered Chef
- Precision Steel Warehouse, Inc.
- RC Willey Home Furnishings
- Scott Fetzer Companies
- See's Candies
- Shaw Industries
- Star Furniture
- TTI, Inc.
- United States Liability Insurance
Group
- Wesco Financial Corporation- XTRA Corporation
12
option of selling his or her business to a private equity firm and may not recognize the business a few
years later, or selling it to Berkshire and receiving assurance that it will still be essentially the same
business decades into the future. Certain sellers are willing to give Berkshire a more reasonable price in
exchange for the assurance that the business that an individual or family spent their lives creating will
continue to run in its current capacity long into the future. This opportunity to purchase at reasonable
prices entire privately held businesses that generate exceptional returns on capital will give Berkshire the
opportunity to continue to grow its portfolio of operating businesses well into the future.
Comparative Analysis: Berkshire Relative to Conglomerates
Evaluating Berkshire relative to other conglomerates will serve as another piece of the framework
within which Berkshire’s target price can be evaluated. The conglomerates chosen for comparison were
Leucadia National Corp. (LUK), Markel Corp. (MKL), Otter Tail Corp. (OTTR), Alleghany Corp. (Y),
and General Electric Co. (GE). Berkshire, Markel, and Alleghany all have significant exposure to the
financial sector, and specifically, the insurance industry. General Electric has limited exposure to the
financial sector through its Commercial Finance and GE Money segments. Leucadia and Otter Tail have
very little exposure to the financial sector, but serve as useful comparisons since they are conglomerates
like Berkshire.
On the basis of earnings, Berkshire is near the expensive end of the group. Using this metric, it is
cheaper than only Leucadia and is very similarly valued to Otter Tail. General Electric, Markel, and
Alleghany all appear cheaper than Berkshire on the basis of earnings. However, when using the price to
book value metric, which is often used when evaluating conglomerates, Berkshire appears to be among
the cheaper conglomerates. While it is still more expensive than Alleghany, it is only slightly more
expensive than Markel on the basis of price to book value. Using this metric, it appears cheaper than
Otter Tail, Leucadia, and General Electric. It seems reasonable to conclude that Berkshire’s current price
places it in the middle of the group of conglomerates with respect to valuation. The financial stability of
Berkshire is unmatched by any of the other conglomerates, but aggressive investors may prefer a small
BRKA LUK MKL OTTR Y GE
Forward PE 21.7 33.6 15.3 18.4 14.9 13.3
Trailing PE 20.5 33.6 11.6 21.6 14.9 14.2
Price to EBITDA 9.9 99.9 7.5 7.1 6.2 5.5
Price to Sales 1.8 9.2 1.7 0.9 2.2 1.8
Price to Book 1.6 2.2 1.5 2.1 1.1 2.6
Price to Cash Flow 16.3 30.0 11.2 10.6 14.0 9.7
PEG Ratio 1.4 7.6 1.2 3.1 3.5 1.2
Return on Equity 7.9 7.1 13.5 9.9 8.0 18.8
BRKA Relative to Conglomerates
13
conglomerate such as Markel if they desire the potential for the types of return that Berkshire was able to
generate in the 1970s and 1980s. These investors must realize however, that in choosing Markel over
Berkshire, they would be trading a steady 10% to 15% return for significantly greater uncertainty. Given
Berkshire’s financial stability and the predictability of its earnings over the long-term, Berkshire seems to
be fairly valued relative to other conglomerates.
Comparative Analysis: Berkshire Relative to Insurers
Although Berkshire is a conglomerate, insurance premiums generated by its various insurance
businesses accounted for 26.9% of Berkshire’s revenue in 2007. Because Berkshire has such large
exposure to the insurance industry, evaluating its current valuation relative to major insurers will also be a
valuable piece of the investment framework within which Berkshire’s target price can be evaluated. A
diverse set of insurers was chosen since Berkshire has insurance businesses in each segment of the
insurance industry. The insurers chosen for comparison were American International Group (AIG),
Allstate Corp. (ALL), AXA (AXA), Allianz SE (AZ), ING Groep NV (ING), and Progressive Corp
(PGR).
On the basis of earnings, Berkshire is the most expensive of the group of insurers. On the basis
of price to book value, Berkshire is the second most expensive insurer, with only Progressive being more
expensive. However, the PEG ratio places Berkshire in the middle of the pack of insurers, primarily due
to Berkshire’s higher projected earnings growth in 2008. The primary reason for Berkshire being more
expensive than its peers in the insurance industry is because of its exposure to industries outside of
insurance. As is discussed in the subsequent Risks and Concerns section of the paper, the outlook for
insurers in 2008 is quite unfavorable. Value Line describes the industry as “fiercely competitive”5 and
notes that this competition will place pressure on insurance premiums, margins, and profits in 2008.
Because Berkshire possesses unmatched financial stability in the insurance industry, is known for its
underwriting standards, has not suffered major write-downs like many of its insurance peers, and has
5 Gendler, Ian. "Berkshire Hathaway." Value Line. 15 Apr. 2008 <www.valueline.com>.
BRKA AIG ALL AXA AZ ING PGR
Forward PE 21.7 10.7 8.7 8.3 7.4 7.4 15.7
Trailing PE 20.5 20.4 8.4 11.4 18.4 6.3 13.4
Price to EBITDA 9.9 21.5 5.3 6.4 3.6 4.8 7.5
Price to Sales 1.8 1.0 0.8 0.5 0.6 0.8 0.9
Price to Book 1.6 1.2 1.4 1.2 1.2 1.5 2.7
Price to Cash Flow 16.3 12.8 7.2 11.4 14.3 5.6 10.0
PEG Ratio 1.4 0.7 1.1 1.4 1.8 1.5 2.3
Return on Equity 7.9 4.9 16.2 10.1 6.7 24.7 18.1
BRKA Relative to Insurers
14
exposure to numerous industries outside of insurance, it deserves to trade at a premium to its peers in the
insurance industry.
Discounted Cash Flow Analysis
Income Statement Projection
Appendix 2 contains the income statement forecast and discounted cash flow model for Berkshire
Hathaway, yet another important piece of the framework within which Berkshire’s target price can be
evaluated. An emphasis was placed on conservatism in choosing estimates for 2008, 2009, and 2010, and
therefore, estimates were chosen that were conservative relative to their averages over the prior 5 years.
Key assumptions are listed below:
• Operating Revenue: Historic growth rates of individual business segments were used with an
emphasis placed on risks to sustaining these levels of growth.
• Insurance Losses & Loss Adjustment Expense: 19% was used for 2008, 2009, and 2010, which is
higher than the actual rates in 2007, 2006, and 2005 (17.77%, 13.26%, and 18.26% respectively)
to account for the possibility of large-scale natural disasters that would result in a significant
increase in the number of claims.
• Tax Rate: Assumed a 32.75% tax rate.
• Minority Interest and Growth in Average Common Shares Outstanding: Projected based upon
prior 5 years’ growth rates.
• All other items were based on a percentage of revenue over the prior five years, with emphasis
placed on the likelihood of sustainability of recent growth rates.
These assumptions resulted in 2008 earnings per share of $7,525, relative to consensus of $6,851, 2009
earnings per share of $7,861, relative to consensus of $7,376, and 2010 earnings per share of $9,133,
relative to consensus of $12,300. It is notable that only one analyst has projected 2010 earnings per share
according to data provided by StockVal.
Discounted Cash Flow Model
Key Assumptions in the DCF model are listed below:
• Terminal discount rate: 10%
• Terminal free cash flow growth rate: 5%
• Revenue growth: Faded to 5% by 2018
• Operating margin: Remained at 13.50% through 2018
• Tax Rate: Remained at 32.75% through 2018
• Depreciation/Amortization and Capital Expenditures: Faded to offset by 2015
15
Although the DCF Model generates a target price of $170,300, I believe that my target price of
$145,000 is more reliable given the challenging economic conditions in which Berkshire will be
operating. In addition, because of the “conglomerate discount,” the tendency for conglomerates to trade
at a discount to the sum of the value of their parts, using a target price that is significantly below that
generated by a DCF analysis is conservative and appropriate.
Risks and Concerns
Key Manager Risk
The age of Buffett and Munger is a primary concern of many investors considering an investment
in Berkshire Hathaway. Buffett is currently 77 years old and will turn 78 on August 30, 2008. Munger
turned 84 on January 1, 2008. While both are in exceptional health by all accounts, it is apparent that
they cannot run Berkshire forever. They have assured investors that a succession plan is in place and
three top-notch individuals hand-picked by Buffett and Munger have indicated that they would be willing
to move to Omaha and run Berkshire whenever they are given the opportunity. Buffett’s current position
will be separated into two separate positions, Chief Executive Officer (CEO) and Chief Investment
Officer (CIO), to ensure that Berkshire has a specialist in each capacity. While Buffett and Munger are
undoubtedly irreplaceable, they have established a culture and mentality at Berkshire that will last for
decades after they are gone. Buffett has always said that he likes to buy businesses that are “so good even
an idiot can run them,” and to an extent, he has created such a business in Berkshire Hathaway. Even
when Buffett and Munger are no longer at the helm, Berkshire’s operating businesses will continue to be
run in a decentralized fashion as they are now. In addition, the investment portfolio of stocks that
Berkshire intends to hold forever will continue to consistently generate solid returns for decades to come.
The primary concern under new management will be allocation of new capital, which is no small concern
given the enormous amount of cash that Berkshire generates each year, but just as the size of Berkshire
prevents Buffett from producing the enormous returns of the 1960s and 1970s, the size would also make
it difficult for even a series of poor capital allocation or investment decisions to have a significant impact
on Berkshire.
Given the current discount at which Berkshire is trading in the market, it seems apparent that
there is zero “Buffett premium” built into the current price. In fact, if the ages of Buffett and Munger are
partially responsible for the current discount, there may in fact be a “Buffett discount” built into the
current price. The proposition of actually receiving a discount to have the greatest investment team ever
manage an investment portfolio for the rest of their lives seems like quite a favorable scenario for the
16
investor. Nonetheless, many investors are concerned that Berkshire’s shares will decline significantly
when Buffett or Munger passes away. Buffett has said on multiple occasions that he believes the deaths
of he and Charlie will present a buying opportunity for long-term investors. In addition, the $35.6 billion
of cash on Berkshire’s balance sheet as of March 31, 20086 serves as a sort of put option to a significant
share price decline in the event of Buffett and/or Munger being unable to lead the company. If the stock
declines as many investors expect it to when one or both of the managers pass away, Berkshire is likely to
utilize some of its $35.6 billion in cash to repurchase shares at the bargain price, which would create
significant long-term value for remaining shareholders. If Berkshire’s shares were to decline to a level
that the board judged to be unreasonably cheap, the company could also use its AAA credit rating to
borrow capital at a very low interest rate and repurchase shares at the sizeable discount from intrinsic
value, again creating tremendous value for remaining shareholders.
Insurance Industry
The lack of major natural disasters over the past few years has made the insurance industry
extremely competitive and has placed pressure on insurance premiums, margins, and profits. Because
Berkshire is known for having very strict underwriting standards, it is possible that revenues and earnings
generated by Berkshire’s insurance businesses could suffer in the short-term. However, Berkshire’s
strategy of only writing policies if it can profit on the policy itself, in addition to the float, is a prudent
long-term approach, and will prove beneficial to shareholders in the long run.
Another inherent risk in the insurance industry is the potential for large-scale natural disasters that
would be a significant drag on earnings in a given year. Because of Berkshire’s unmatched capital
structure, it is not at risk of these sorts of claims having a significant long-term impact on the company.
In fact, although natural disasters would be a short-term drag on Berkshire’s earnings, they would also
decrease the competition in the insurance industry and would allow Berkshire to realize greater
premiums, margins, and profits in subsequent years.
Even if Berkshire’s insurance businesses do experience challenges in the next few years, the
economics of the insurance industry are highly beneficial for a company with the capital structure of
Berkshire. The float on insurance policies equates to interest-free capital for Berkshire’s management to
strategically invest. When management is given capital at no cost, it has a very low bar that it must step
over to create additional value for shareholders. Assuming that the insurance businesses are able to
maintain their stringent underwriting policies, the float from insurance policies will serve as a constant
source of value creation for Berkshire shareholders.
6 Berkshire Hathaway 1st Quarter 2008 10-Q
17
Derivatives
Since reporting a $1.6 billion mark-to-market loss on derivatives in the 1st quarter of 2008,
Berkshire has been criticized for investing in what Buffett has referred to as “financial weapons of mass
destruction.” Although losses are never good, the $1.6 billion loss reported is merely a paper loss and is
unlikely to ever become a true loss. The loss results from put options that Berkshire wrote on four stock
indices, the S&P 500 and three foreign indices, in 2007. These put options were written at the money and
are not exercisable until expiration, which is between 2019 and 2027. Berkshire received $4.5 billion in
premiums for writing these options. Essentially, the company is predicting that come 2019 to 2027,
stocks will either be higher than they were in 2007 or at the same level. If this turns out to be the case,
Berkshire has made $4.5 billion on the put options despite the paper losses that occurred in the interim
periods. Although certain investors may choose to view this transaction as risky because of the interim
volatility, it seems like a pretty high probability event that stocks will at worst be flat over the next eleven
to nineteen years. If they happen to decline over this period, Berkshire has $4.5 billion in premiums to
cover any losses.
Conclusions
The combination of several factors makes Berkshire Hathaway an appealing investment candidate
at its current price of $123,970. This price is 17% below my conservative target price of $145,000 per
share and equates to a reasonable margin of safety for an investment in a company that possesses
unmatched financial stability and sustainable competitive advantages that characterize its operating
businesses and the businesses held in its investment portfolio. Several key aspects of my thesis are
summarized below:
• The $35.6 billion of cash on Berkshire’s balance sheet as of March 31, 2008 will give the
company opportunities to strategically capitalize on the current market turmoil. During prior
economic downturns, the company has been able to create significant value for shareholders, and
it is not unreasonable to expect that management will be able to repeat this feat under current
economic conditions.
• The financial stability of Berkshire is unmatched. The cash on its balance sheet, coupled with the
company’s minimal leverage, AAA credit rating, and consistent generation of sizeable free cash
flow makes Berkshire the ideal defensive investment.
• Berkshire is a low-risk investment that will allow investors to profit from the eventual
turnarounds of the financial and housing sectors. It is unique to be able to benefit from these
turnarounds without assuming the risks that are associated with pure-play financial and
homebuilding stocks in the current economic environment.
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• At its current price, Berkshire has reasonable upside potential with minimal risk of permanent
loss of capital for the long-term investor. Berkshire is a very low risk proposition for the long-
term investor, and when you don’t lose money, all of the other outcomes are good. The
opportunity to purchase Berkshire at a 17% discount to conservative intrinsic value provides a
reasonable margin of safety for an investment in a company of the caliber and stability of
Berkshire.
• There is zero “Buffett premium” built into the current price and there may in fact be a “Buffett
discount” due the ages of Buffett and Munger. The proposition of actually receiving a discount to
have the greatest investment team ever manage an investment portfolio for the rest of their lives
seems like quite a favorable scenario for the investor.
• Berkshire is a difficult company to value, which is often advantageous for the sophisticated
investor who is willing to work through multiple valuation techniques to establish a framework
within which a target price can be evaluated. Investors who are able to evaluate companies or
situations that others do not fully understand are often rewarded with healthy profits when other
investors later discover the value in a given company or situation.
In conclusion, Berkshire is admittedly not a deep-discount purchase at its current price, but it is
trading at a 17% discount to my conservative target price of $145,000. Several valuation methods
produced valuations that are significantly greater than my target price of $145,000, including the DCF
model, which produced a target price of $170,000. However, in the interest of conservatism and
acknowledging the conglomerate discount that has been evident in the markets over time, $145,000 seems
to be a reasonable target price. At its current price, I believe that an investment in Berkshire offers a very
high probability of consistent and reasonable returns to the long-term investor. The sizeable upside
potential coupled with minimal downside risk makes Berkshire Hathaway a prime investment for
investors with a long investment horizon.
19
Appendix 1: Berkshire Hathaway Financial Statements from Company 10-K
20
21
22
Appendix 2: Berkshire Hathaway Income Statement Forecast and Discounted Cash Flow Model
23
DCF Valuation
5/24/2008
Ticker: BRKA Terminal Discount Rate = 10.0%
Terminal FCF Growth = 5.0%
Forecast Terminal
Year 2008E 2009E 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E Value
Revenue 127,993 143,611 163,138 182,715 200,987 219,075 236,601 253,163 268,353 281,771 295,859
% Growth 12.20% 13.60% 12.00% 10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 5.00%
Operating Income 17,919 18,885 22,024 24,667 27,133 29,575 31,941 34,177 36,228 38,039 39,941
Operating Margin 14.00% 13.15% 13.50% 13.50% 13.50% 13.50% 13.50% 13.50% 13.50% 13.50% 13.50%
Taxes 5,868 6,185 7,213 8,078 8,886 9,686 10,461 11,193 11,865 12,458 13,081
Tax Rate 32.75% 32.75% 32.75% 32.75% 32.75% 32.75% 32.75% 32.75% 32.75% 32.75% 32.75%
Minority Interest 400 510 625 750 875 1,000 1,125 1,250 1,375 1,500 1,625
Net Income 11,651 12,190 14,186 15,838 17,372 18,889 20,355 21,734 22,988 24,081 25,235
% Growth 4.6% 16.4% 11.6% 9.7% 8.7% 7.8% 6.8% 5.8% 4.8% 4.8%
Add Depreciation/Amort 2,560 2,944 3,344 4,111 5,025 6,025 7,098 8,228 8,721 9,158 9,615
% of Sales 2.00% 2.05% 2.05% 2.25% 2.50% 2.75% 3.00% 3.25% 3.25% 3.25% 3.25%
Plus/(minus) Changes WC (128) (144) (163) (183) (201) (219) (237) (253) (268) (282) (296)
% of Sales -0.10% -0.10% -0.10% -0.10% -0.10% -0.10% -0.10% -0.10% -0.10% -0.10% -0.10%
Subtract Cap Ex 5,888 6,750 7,749 7,765 8,039 8,215 8,281 8,228 8,721 9,158 9,615
Capex % of sales 4.60% 4.70% 4.50% 4.25% 4.00% 3.75% 3.50% 3.25% 3.25% 3.25% 3.25%
Free Cash Flow 8,195 8,241 9,618 12,001 14,156 16,479 18,936 21,481 22,720 23,800 24,939
YOY growth 1% 17% 25% 18% 16% 15% 13% 6% 5% 5%
Terminal 523,729.1
Terminal Value 523,729 P/E 20.8
NPV of free cash flows 96,378 37% EV/EBITDA 10.75
NPV of terminal value 166,876 63% Free Cash Yield 4.76%
Projected Equity Value 263,254
Free Cash Flow Yield 3.11%
Shares Outstanding (mil) 1.545751
Current Price 123,970.00$
Implied equity value/share 170,308.23$
Upside/(Downside) to DCF 37.38%
Cash 44,329
Debt 53,472