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Author: gramphilwar One star, 50 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 211757  
Subject: Re: book value Date: 10/11/2006 11:52 AM
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I think that using book value analysis to find BRK's intrinsic value might introduce too much error, since as WEB has stated before, IV closely tracks, but usually somewhat exceeds, the gain in IV year over year.

Over time, small differences in the annual rate of gain of book value versus the rate of gain in IV will eventually lead to large gaps between the two numbers.

Perhaps IV might be more closely approximated using the two-table columns that are sometimes provided to us in the annual report?

The '05 AR reported net value of cash and marketable securities at $74,129 per A share with $2441 per A share in annual pre-tax earnings in the non-insurance businesses. I like to value that 74K at market, and use the difference between that number and market price per share as the amount you pay for the operating subsidiaries.

If you notice in the '05 AR, the two table column only lists the earnings from the non-insurance subsidiaries. We can probably treat these as recurring and can apply an appropriate multiple based on expecations of growth (both organic and via acquisition) and returns on equity or carrying value, etc etc. Or you could apply a multiple on the earnings expecting them to be static, and use your expectations of growth as a margin of safety.

So I think you can pretty much arrive at a conservative estimate of intrinsic value by adding the market value of the investments plus the pre-tax operating earnings of the non-insurance subsidiaries times an appropriate multiple. For example, if the appropriate multiple is 10, then you get an IV of BRKA as 74,129 + 24,410 = $98,539.

Of course, this is a static value being applied with false precision to something that in reality is quite more dynamic, but what the heck, it's a rough guess and we can round it.

Note also that this guesstimate for IV applies to a snapshot of BRK at year end '05, and it has changed since then with some acquisitions (I'm thinking of Iscar, the new Gillette), and might have some more cash and/or marketable securities added from a full year of operating. More likely than not, the IV has shifted upwards in both columns since the last time WEB reported.

I like this method because the equation is pretty simple. I don't need to think too hard about the value of the investment income and the lumpy underwriting gains of the insurance subsidiaries because it's not included in the equation. I don't need to try to value what crazy mispricing in the markets that WEB might be able to find and exploit (like junk bonds). Instead, I trust that Berkshire culture will continue to work hard to minimize the cost of the float and that a permanent loss of capital in that arena will remain unlikely. I also trust that WEB will do his best to enter transactions that limit the downside while providing an attractive return on capital. This way, if negative cost of float does occur in insurance or if WEB scores a coup in the markets, it'll be a pleasant surprise; but either way I'm not going to assign either of those unpredictable events a value--essentially, I'm going to pretend that in these activities Berkshire and Buffett are about as good as a coin flip with even odds (when clearly both have a significant edge in their respective activities). Also, if I'm convinced that the marketable securities are overvalued (as they were during the late '90s) or undervalued, I can easily adjust the value in the equation accordingly.

All the hard thinking I really have to do is to ponder whether or not I think the operating earnings could be permanently impaired, and conversely, the likelihood that the largely diversified non-insurance subsidiaries will continue to provide a (hopefully growing!) stable stream of earnings.

The other thing I've realized is that when you calculate IV this way, in order for the IV to really grow in current market conditions, WEB needs to make some pretty big acquisitions in order to keep the recurring earnings portion going. This is going to be hard. In this respect, I'm happy that he and Charlie are widening their hunting grounds to outside the US because it increases the chances that something good will happen. No one can predict what will happen with with any certainty, but they both have had a pretty good record so I'm looking forward to seeing how this all develops.
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