2. Berkshire Hathaway
Financial
Yichen Fan 2 Seattle University
Redhawk Fund
Ticker: NYSE:BRK-B Recommendation: ●BUY
Current Price: ● $151.54 Price Target: ●$170
INVESTMENT THESIS
o Low cost of large size float: BerkshireHathaway Inc.’s insurance subsidiaries have a track record of high
quality underwriting, having generated underwriting gains for last three years. The good insurance
performance provided zero or even negative cost of capital to Berkshire Hathaway Inc.’s portfolio. Moreover,
this float is growing at an incredible rate. This is an important distinction between Berkshire and other
investment funds, which are dependent on thepublic market.
o Stable andremarkable investment: Berkshire Hathaway Inc. consistently beat the market for several years.
With the best capital allocation in theworld, it earns above average and consistent profit. It is less risky
because it engaged in diversified business. Compared with other funds, Berkshire has better access to non-
traditional investment opportunities. For example, it can buy another business as a subsidiary. Because of the
good reputation, many investment ideas flow to Berkshire first before anyonecould get it.
o Safety: Rock solid financial strength and famous reputation gives Berkshire Hathaway Inc. unmatchable
competitive advantage in insurance industry. It is not subject to liquidity risk no matter what happened in
equity market. Furthermore, Berkshire and its subsidiaries are engaged in diversified businesses, which
reduce the unsystematicrisk for the stock.
• 5-Year Stock Price Trend –
3. Berkshire Hathaway
Financial
Yichen Fan 3 Seattle University
Redhawk Fund
From the given 5-year stock price chart, BRK-B shares have outperformed the S&P 500
by around 50%.
Market Profile
Market Cap. 248.86M ROA 4.13%
52 Week Range 44.82 ROE 9.30%
Dividend/Yield N/A ROI 7.86%
P/E Ratio 17.2 Profit Margin 10.69%
Forward P/E Ratio N/A Quick Ratio N/A
Beta 0.29 Current Ratio N/A
BUSINESS OVERVIEW
Berkshire Hathaway Inc. is a publicly owned holding company. It was founded in 1889 and is based in Omaha, Nebraska as
a textile company. The chairman, main shareholder and CEO of the company, Warren Buffett, bought the company at 1962 and
expand it to insurance industry and other investment. Berkshire Hathaway Inc. owning subsidiaries engaged in diversified
investments, property &casualty insurance and railway.
• Berkshire Hathaway Inc.’s insurance and reinsurance business activities are conducted through GEICO, General Re,
Berkshire Hathaway Reinsurance Group and Berkshire Hathaway Primary Group. Thesebusinesses generate large
amounts of float, which can be invested in high quality bonds or treasuries. Theseinsurance companies providelow
cost float to investment, as it is essentially free. The insurance and other financial services cover 65% of Berkshire
Hathaway Inc.’s Asset.
• Through its subsidiaries, Berkshire Hathaway Inc. provides financial services and financial products. These
businesses represent 5% of Berkshires’ Asset.
• The company holds 47 stocks included Wells Fargo & Co., Bank of New York Mellon Corp., Chicago Bridge& Iron
Company N.V. etc. among 12 sectors and mainly weighted in Financials (43.8%) Consumer Staples (24.74%) and
Information Technology (13.07%). Thevalue of the whole portfolio over 110 billion.(CNBC)
• By its subsidiaries, Berkshire Hathaway Inc. also engaged many other industries, which includes railroad, utilities and
energy. Mr. Buffett provides theoversight to each subsidiary CEO and CEOs are responsible for their specialized
businesses. However, Mr. Buffett will take charge of the free cash flow generated by each subsidiary and reallocates
capital to subsidiaries or investments. These businesses covered 30% of Berkshire Hathaway’s Inc.
4. Berkshire Hathaway
Financial
Yichen Fan 4 Seattle University
Redhawk Fund
FinancialPerformance
• Liquidity: Berkshire Hathaway Inc.’s balance sheet reflects significant liquidity. It owns a s strong reserve and huge
amount of trading securities. Berkshire Hathaway Inc. can use themoney to pay its policy holder’s claim.
• Book Value per Share: Berkshire Hathaway Inc.’s Book value has grown around 10% over the
last 10 years. During 2011-2012, it grew at two digit rates. Because the company repurchases its
shares when the P/B ratio is below 1.2, the book value can set a floor for the share price.
2014
E
2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Average
Book Value Per
Share
105 94.93 80.32 70.21 67.1 59.33 49.37 54.61 49.2 41.58 39.1
Growth rate 11%(E) 18% 14% 5% 13% 20% -10% 11% 18% 6% 11%
•
Industry Overview and Competitive Positioning
• Macroeconomic Factors and industry overview:
o We expect that the U.S. economy will grow fasterin 2015: After slowing down in thelast quarter of
2014, we forecast the GDP will perform strongly in thefollowing quarters because of thecontinued job
growth pulls the consumption.
o We are cautiously optimisticforinsurance industry for next year: Insurance industry is a business with
little scopeof differentiation. The demand side is relatively stable and thesupply sidedepends on capital. It
has earned year-over-year earnings gain because fewer claims were paid in 2014, but it also pressures the
rate for next year. We believe that most insurance companies can get a reserve-to-loss ratio of three to one,
which can cover an about-normal level of catastrophes. Because of past events, we observed theinsurers
have tightened standards and enforce it. Therefore, though the industry is really depending on theweather,
we are optimisticfor theindustry next year.
o The oil price drop has hurt the Berkshire Hathaway Inc.’s interest: Thehuge drop in oil price from
$110/barrel to less than $70/barrel did significantly damage in energy sector. It lost 12% on thetotal return
basis during 2015. Berkshire Hathaway owns roughly $5.1 billion shares in five energy stocks (XOM, COP,
NOV, PSX, SU). In addition, two of Berkshire Hathaway Inc.’s subsidiaries, Burlington Northern Santa Fe
railroad and Berkshire Hathaway Energy, even have more exposure to oil prices.
RISK ASSESSMENT
• Key people: Berkshire Hathaway Inc.’s Major investment decisions and all major capital allocation decisions are
made by Warren E. Buffett, Chairman of theBoard of Directors and CEO, age 83. In the past several decades, Mr.
Buffett has proved extraordinary investment skills and accomplished unprecedented achievement. Concerning Mr.
Buffett’s age, if his service is unavailable, it will be a great loss for Berkshire Hathaway Inc. It is obvious that there is
nobody with such a reputation and experience as Mr. Buffet. After Mr. Buffett, it appears that Mr. Buffett’s position
will be split into three positions after he retires. It is doubtful that if the inheritors could cooperatewell and meet the
5. Berkshire Hathaway
Financial
Yichen Fan 5 Seattle University
Redhawk Fund
market expectation to Warren Buffet. For now, Howard Graham Buffett, the second son of Mr. Buffett, is expected to
be the chairman and two of Mr. Buffett’s lieutenants, Todd Combs and Ted Weschler, may take important positions
because of their unexpected frequent involvement in the business recently. However, we also noticed that this risk
remain for Berkshire for the last ten years, it is reasonable to assume that the market has already prepared for his
retirement. In this report, wedidn’t give any credits to Mr. Buffett’s investment skills.
• Estimation of insurance expense: Insurancebusiness is fundamentally hard to predict. Berkshire Hathaway Inc.’s
insurance business may suffer unexpected loss from natural catastrophes, terrorist, disease, or other unforeseen events.
For thepast five years, thefloat for Berkshire has grown at 5.8%, which is an incredibly high rate for an insurance
company. Mitigating this risk, however, is Berkshire’s good reputation in its underwriting quality. We suspect
Berkshire can generate underwriting gains in thefuture. In our report, we will use conservative number for thecost of
float.
• Risk of extraordinary event to investment portfolio: Base on Berkshire Hathaway Inc.’s portfolio size, we believe
that the investments are too concentrated, and some stocks, such as Wells Fargo, Coca Cola, American Express and
Walmart, are highly overweighed. We agree that these stocks are extremely valuable, stable and have “economic
moat”. We also agree that this small number of stocks is incredibly diversified in different industries. However, we
still suspect therisk of an extreme event to one of overweighed stocks may cause huge loss.
• Risk of regulation: Theinsurance companies have been hardly regulated. Regulations require every company to hold
statutory reserves. However, it is possiblethat regulators will start to restrict the investment types for float. Some
countries, like China, require thestock investment cannot exceed the20% of total capital. If theU.S. regulator
conducts a more conservative regulation, Berkshire Hathaway Inc. may lose its competitive advantage.
VALUATION
• Direction: Because of the complicated business structure, it is hard to simply use a basic valuation model and it will
be too detailed to value each subsidiary in its applicable different way. However, most of investors believe that Berkshire
Hathaway Inc. has two main values which were endorsed by Mr. Buffett. One of them is its insurance operation, included
the value of insurance operation, float and securities. The other one is its non-insurance operations, included its
diversified non-insurance subsidiaries. Therefore, we would like to use a sum of parts approach valuing individual
business segments using methods appropriatefor each.
• Assumptions:
o Methodology selection: BerkshireHathaway Inc. is largely engaged in financial services, which is hard to
use a traditional discounted cash flow model for because the reinvestment will be treated as expense in
accounting. It also doesn’t pay dividends. Therefore we will use Float Based valuation to value theinsurance
business. Float-based valuation was pioneered by Alice Schroeder and Gregory Lapin in their well-known
paper on Berkshire Hathaway published in 1999. Its values intrinsic value is a sum of the net tangible assets
and the estimated value of float. We believe it is a good model here because the float is themain driver of
Berkshire’s value. This would be theprimary approach used to value insurance segment in this report. We
will use P/E multiplier to value other businesses. Base on the diversified companies, we believe industry P/E
ratio is comparable. Since float-based valuation is controversial and is sensitive to inputs, wewill also
present Price-Book multipliers valuation as a yardstick because P/B ratio is widely acceptable and accurate
for financial services companies.
o Class B stocks: Berkshire Hathaway Inc. decided that theClass-B price per share will not exceed 1/1500
Class A price per share. From historical price, we observed that the Class-B stock share price concisely stay
in the price ceiling. We believe that we can assume one share of Class B share price equal to 1/1500 of one
share of class-A stock price.
6. Berkshire Hathaway
Financial
Yichen Fan 6 Seattle University
Redhawk Fund
• Valuation Model
o Float BasedValuation and P/E MultiplierValuation:
▪ Insurance Subsidiaries(Float BasedValuation):
• Model: In Float Based Model, we will calculate the intrinsic value of Berkshire
Hathaway’s insurance business by adding the net present value of the forecasted cash
flows emanating from the use of policyholder float to the statutory capital levels held in
the insurance business.
• Float: The float in Berkshire has grown at 5.8% for past five years, which is a rapid rate
for insurance companies. We believe the float will keep growing at 3.5% in perpetuity,
which is considered as the normal growth rate. If the rate is higher than 4%, we believe
that will be a negative sign to the underwriting quality. Berkshire Hathaway Inc.’s
insurance subsidiaries generate underwriting gain over past three years, so the cost of
float is at a negative rate. However, considering the high growth rate for float, we believe
it is more conservative to assume thecost of float is closer to zero.
• Return: We assume the return of float will not far exceed the 30 years treasury yield.
The current 30 years treasury yield at 2.8%, but we believe it will rise to normalized
levels soon. Therefore, we project 5% return on float base on the 30 years treasury yield
before the recession. Note that this does not give any credit to Mr. Buffett’s investment
skills because he could retire at any time.
• Discount rate: We give six percent discount rate because Berkshire is a triple A
company and it can generate capital by float for free. It will be unrealistic to use beta to
estimate the cost of capital for Berkshire.
• Statutory capital: $129 billion (2013 annual report, page 91)
• We estimate thevalue of insurance operation is $299 billion
▪ Financial services(P/E):
• Projected Earning: The pre-tax operating income for Berkshire Hathaway Inc.’s
financial services is $3,642 million for 2013. The growth rate is close to 13%. We
estimate it will grow at the same rate which will result in approximately $4 billion of
pre-tax income, which makes tge the after tax operating income from financial service
operation is around 2,800 million.
• P/E ratio: According to Yahoo Finance, the average P/E ratio for non-banking financial
service company is 11.26. We believe this P/E ratio is reasonable.
• We estimate the value of financial services operation for Berkshire Hathaway Inc. is
$31,528 million.
▪ OtherBusiness(P/E):
• Projected Earning: Except insurance and financial services, Berkshire Hathaway Inc.
also engaged in many different businesses. Because of diversified businesses and the
exposure in oil price, we assume it will not exceed the net income last year. We will use
the P/E ratio of S&P 500. The before tax operating income from other businesses in 2013
is close to $7034.5 million. We estimate the after tax operating income from other
businesses in 2014 will be close to $4,900 million, which is same as 2013. The P/E ratio
for S/P 500 is 19.48
• We estimate the value of other business operation for Berkshire Hathaway Inc. is
$95,452 million
7. Berkshire Hathaway
Financial
Yichen Fan 7 Seattle University
Redhawk Fund
▪ Intrinsic value per share: We estimate the total value of equity is $425 billion. By assume the
price of Class-B stocks is 1/1500 of class A stocks, we estimate the intrinsic value for Class-B
share is $177 per share.
o P/B MultiplierValuation:
▪ Growth: During the past two years, thebook value of Berkshire Hathaway grows around 16%. It
is mainly because the stock repurchase However, we expect theincrease rate will drop to because
the large sizeof capital base. We believe 11% will be a proper growth rate because it is the average
BV growth rate for last 10 years.
▪ Multiplier: Since Berkshire’s main value is contributed by its insurance business, their asset is
highly liquidity. Therefore, we believe P/B ratio could provide a bottomline for the value of
Berkshire. Because Berkshire Hathaway Inc. is highly diversified and theprice of stock is
influenced by many factors, we decide to use different P/B multipliers to value different businesses
and sum them up. We decide to break Berkshire to insurance business, financial service business
and other business. Moreover, because the new stock repurchases policy discussed above, we
believe it is reasonable to estimate the P/B leading multiplier will be slightly higher than the
average of P/B multipliers before recession.
▪ We estimate thevalue of to be $168/share.
RECOMMENDATIONS
We give a cautious buy recommendation to Berkshire Hathaway Inc. The company has its “economic moat” built from
its competitive advantage. We estimate the Berkshire Hathaway Class-B shares intrinsic value as of year-end 2014 is in the range
of $172 to $177. In our view, a substantial margin of safety exists for shareholders at prices below $170 per Class-B share. The
main reason to buy this stock is because of the large and no cost float, remarkable investment return, and diversified business.
We believe the stock price remains 10% upside potential. Buying the stock at $170 per share is a fair value for the outstanding
business and obtains satisfactory return.
8. Berkshire Hathaway
Financial
Yichen Fan 8 Seattle University
Redhawk Fund
EXHIBIT 1: INCOME STATEMENT
in millions
SOURCE: COMPANY DOCUMENTS, STUDENT ESTIMATES
10. Berkshire Hathaway
Financial
Yichen Fan 10 Seattle University
Redhawk Fund
EXHIBIT 3: STATEMENT OF CASH FLOWS
in millions
SOURCE: COMPANY DOCUMENTS, STUDENT ESTIM ATES
11. Berkshire Hathaway
Financial
Yichen Fan 11 Seattle University
Redhawk Fund
Exhibit 4 Float-Based Valuation Analysis
Insurance Subsidiary Valuation= Present value of float + Statutory capital
Present Value of float= next year Cash Flow/Capitalization Factor
(We will treat thepresent value calculation as a “growing perpetuity”)
Where: Next year Cash Flow= current float*(Investment Return-Cost of Float-Tax Burden)
And: Capitalization Factor= Discount Rate- Growth Rate
Value($ in
million)
Float 2014(billion) 79310 (3% grow from lastyear Insurance 298917.7095
Return of Float 5% Anticipated 30 years
treasury rate
Financial service 31500
Cost of Float 0 Other business 95500
Tax 1% Estimate by Mr. Buffett Total value 425917.7095
One year cashflow 3172.4 Class A shares
outstanding
1.6
Discount rate 6% Anticipated 30 years
treasury rate
Class B shares
outstanding
1.64
Growth rate 3.5% growing perpetuity Instinctvalue of
Class-B shares
177.3445269
Capitalization Factor 2%
Present value of float 169917.7095
Statutory Capital 129000 2013 annual report
Insurance valuation 298917.7095
SOURCE: COMPANY DOCUMENTS, STUDENT ESTIM ATES, MORNINGSTAR.COM
12. Berkshire Hathaway
Financial
Yichen Fan 12 Seattle University
Redhawk Fund
Exhibit 5 P/B Ratio Valuation Analysis
BRK.B Estimate Insurance Industry Avg. S&P500 Financial Industry Avg.
1.64 1.2 2.7 1
65% 30% 5%
BRK.B Book
value per share
BRK.B Estimate BV
Multiplier
BRK.B instinctvalue pershare
105 1.64 172.2
