It Is Unlikely I’ll Invest In Berkshire Hathaway Soon (NYSE:BRK.A)

Despite being a large business, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) is simple as an investment; you just need to know the key factors about it to understand the most likely investing outcome. Those key factors are its business quality, valuation/price and then the most important thing; investment timing and sizing.

Business Quality/No Risk There

Berkshire is a financial fortress made to last and compound over time. Buffett and Munger know that most businesses go bankrupt over time, and therefore, Berkshire is structured in a way not to allow going bust. By having $123 billion in cash and cash equivalents, you can be pretty sure that all the possible insurance obligations will be covered even in the worst-case scenario, thus Berkshire won’t go bust that easily.

If a business doesn’t go bust, it can compound over time. For long-term compounding, Buffett likes to invest in great businesses with strong cash flows at a fair price. Those businesses include Apple, Burlington Northern, GEICO, Bank of America, Coca-Cola and many more…

As the business is well known, let’s focus the trickier part, valuation.

BRK Stock Valuation/Price

As shown above, Berkshire is Berkshire, the key question to answer is at what price it fits your portfolio. For that, we need to get to Berkshire’s ‘true earnings’ as Buffett likes to say, then we can make a valuation and understand the price at which it would fit your portfolio.

Earnings

In a stable economy, Berkshire makes approximately $7 billion in free cash flow/profit per quarter like it did in the last quarters, thus $28 billion per year.

To the earnings from the owned businesses, you can add approximately $8 billion per year in earnings that the businesses in the stock market portfolio earn but don’t pay in dividends, which is the income part not accounted for in Berkshire’s financial statements. As Berkshire doesn’t own more than 50% of those businesses, accounting rules state that those earnings are not consolidated into its financial reports.

Example: Berkshire owns 5.6% of Apple, where Apple’s trailing twelve months net income is $99.8 billion. Thus, Berkshire’s share of Apple’s profits is $5.6 billion. However, as Apple has a 14.8% dividend payout ratio, only the dividend is accounted for into Berkshire’s financial statements, approximately $820 million.

The remaining $4.8 billion are not accounted for and can be considered hidden earnings. If we add the other companies that don’t pay out all their profits into dividends, like American Express, we quickly surpass $8 billion in hidden earnings. You can read more about the way Berkshire’s manages earnings in their Owner Related Business Principles, principle number 6:

Berkshire’s Owner Related Business Principles

To sum up, on a yearly basis, we are at $36 billion of earnings or better to say value creation. Let’s go to valuation.

Note: you need to adjust Berkshire’s earnings for the changes in value of the stock market portfolio under the account ‘investment and derivative gains (losses)’ – totally wrong accounting there, but that is the law, even Warren discussed that in almost every letter. Berkshire’s reported earnings move up and down depending on the swings of the stock market in relation to its stock portfolio. That is obviously irrelevant for long-term investors.

Valuation

If the average earnings are $36 billion with likely growth of an average 6% in the future based on the assumption that Berkshire will continue to reinvest all its profits and target returns on investment of 8 to 10% as Charlie and Warren often stated, where I deduct two percentage points to account for recessions over time.

If we make a short intrinsic value exercise, using a 10% discount rate and various terminal multiples, we get to the following valuations for Berkshire.

BRK Stock Valuation – Source: Sven Carlin (free template download)

In my normal case scenario, with growth of 6% per year and where its valuation reverses to the historical mean of 15, expecting a 10% investment return per year, Berkshire is extremely overvalued, and it should fall almost 50% to offer a 10% yearly investing return.

To justify the current market perspective on Berkshire, if one would expect a 10% return going forward, it should grow at 8% and then have a 25 PE ratio, which is very unlikely.

If I adjust my expected return or the discount rate to 6%, put a more likely PE ratio of 17 and allow for 8% growth per year, also a stretch in my opinion, but only in such an exuberant scenario one could say BRK would be fairly valued at the moment.

A 6% return is not bad for most people, but likely not worth the risk of a worst-case scenario. If Berkshire grows just 5% per year going forward and then get a PE ratio of 15, the terminal market capitalization 10 years from now would be $837 billion for a miserable 2% yearly investing return.

At current levels, it is likely investing in Berkshire will lead to positive returns over time. That is not bad given BRK’s quality and low risk, but still, one should mind the best exposure to one’s portfolio as it is unlikely the returns will be as good as those were in the past.

Investment timing and portfolio exposure

The average historical PE ratio for Berkshire is 15. In exuberant times it reaches 20 and falls to 10 in panicky times when the predominant mantra is that Buffett is old and has lost his touch. (we can’t use the PE ratio from 2019 onwards due to the change in accounting for profits – has to be adjusted)

If we use a PE ratio of 10, BRK is a great buy at a market capitalization of $360 billion. We were close to that in the period from March to May 2020 as I said in March of 2020.

But now, we are far from the March 2020 values and therefore the investing risk is much higher while the returns ahead will clearly be lower.

What Has To Happen For Me To Own Berkshire

To invest in BRK stock with low risk and the highest return possible, it is better to buy BRK when the PE ratio of its average earnings is around 10. I would define BRK’s average earnings as what it makes in a good business year. In the next recession, earnings should be lower, and the market might react negatively, creating a better buying opportunity. Now, BRK is closer to the higher range of its historical PE valuation and the market is currently paying a premium for its quality. Thus, the returns are likely to be lower in the future.

You might think that given Berkshire’s quality, at a PE ratio of 10, I would load the truck with BRK stock. Not that fast because if there is a recession, it is very possible that BRK will drop 50% to a PE ratio of 10. But, if a recession happens, there could be much better risk and especially reward opportunities out there. As the economy gets back on track, BRK stock might double, but if you buy something else, like cyclicals, you might have better returns.

The only possibility for me to own BRK is a 2000 situation when the market was infatuated with dot-com stocks and trashed BRK and Buffett. Only is such a situation, where there are no other opportunities, BRK stock might be attractive to me.

From an absolute return perspective BRK is an amazing buy at a PE ratio of 10, but at that point, from a relative perspective it could still be expensive given that other things might be much cheaper and offer much better reward opportunities for slightly higher risks. As always, the best time to buy BRK stock is when headlines discuss how Buffett lost his touch.

To conclude, Berkshire is one of the best businesses out there and will certainly compound your money over the next decades. Also, it will be a good investment if you don’t have better, but I think that with a bit of effort one can find better. If you can’t, then sure, BRK stock is one of the best investments you can make out there!