Market Value of Equity: $210BB
Less Owned Stocks,Bonds, Cash: $158BB
Plus Liabilities: $66BB
Value of Owned Businesses: $118BB
After tax earnings 2011 est: $12.5BB (excluding gains on stocks, interest)
Multiple on owned businesses: 9.4x
See the Intrinsic Value section in his 10K.
So I should point out that this stock has traded at a sub-market multiple for years. I suspect concerns for BRK are 1) its size limits its growth potential, and 2) Buffet is 80 years old now and questions of succession are quite valid. But I still question the market valuing this at 9.4x earnings vs a market at 15x!
Isn't the worst case that Buffett passes away with no heir, and they break up the business? Or that new management is inept? I think if they broke up the businesses, it would yield far higher than where the stock is trading. And I also think that Buffett is too smart not to find very able managers to run this after he is gone. Everything I have read about Todd Combs and Ajit Jain and David Sokol are more than positive.
The stock also trades at 1.35x book value, which doesn't seem cheap to some. However, the 10 year average price-to-book is 1.6x, so its relatively cheaper than its typically traded. Also, BOOK is merely the cost basis of companies he has bought. You cannot write UP goodwill for deals like Geico, as he points out in his letter. While he paid $4.6BB for Geico in 1996, today its generating $14BB in premium, and generated over $1BB in profits last year. He points out that its likely worth $14BB vs a book value of $4.6BB.
Same math applies to his $34BB purchase of the rail company Burlington Northern. While he seemed to have overpaid in 2009 for it, its profits have increased from $1.7BB to now it will likely do $3BB plus in profits in 2011. That makes his $34BB purchase probably worth $45BB in less than 18 months. These are just two examples of intrinsic worth being much higher than book.
So you can buy a decent chunk of BRK/B, and I think expect to see reasonable returns. The stock is actually only up 6% over the past 12 months, vs the S&P 500 up 22% over the past 12 months. It's going to catch up.
If you are curious which stocks Buffet owns within BRK, here are his biggest investments, largest to smallest:
1) Coke, KO
2) Wells Fargo, WFC
3) American Express AXP
4) Procter & Gamble, PG
5) Kraft, KFT
6) Munich RE,
7) Johnson & Johnson, JNJ
9) US Bancorp USB
10) Walmart, WMT
ANOTHER OVERHANGIf you follow BRK and are concerned about the $37BB in very long dated put options he wrote to undisclosed investors, here is the math on them today.
Estimated Strike: S&P at 1400
Time entered into contracts: 2006-2007
Expiration date (average): 2024
Net liability on balance sheet: $4BB (marked to market losses recognized to date)
So he received $4.9BB in premium for very long dated at the money puts on the S&P. He unwound 8 of the 47 puts in 2010. I figure 30BB are left, so if the S&P is at 1000 in 2024, down 25% from today, then future liabilities would be about $4BB. That's a 1.8% hit to the stock. If the market is at least 1400, then he'll have $4BB in gains to realize. Not a concern to me. My question is, who is dumb enough to buy 15 year S&P puts from Warren Buffett, and pay a big premium for volatility????
APPLYING BUFFETT METHODOLOGY
I like to delve further and try to understand how Buffet values businesses. It's very obvious in reading his letters that he appreciates cost controls, good management, and smart capital allocation. That is, not frittering away free cash flow on overpriced acquisitions or silly expenditures that generate little in the way of returns. This is perhaps the biggest flaw in management that I see.
But what I want to know is, How does Buffett value stocks? This he will not tell anybody. But if you are a bit of a Buffett follower like me, then you read all his annual letters and books written about him. Even once I made the pilgrimage out to Omaha to see the Oracle, as he is named. In addition to some of the above items, I think he focuses heavily on
1) high free cash flow (FCF) yields,
2) solid returns on equity (ROEs),
3) buying companies you understand, with a moat around them, and
4) owning good businesses forever.
That's about it. He says things like, "I know in 20 years people will still be drinking Coke" so he would own KO. In fact he's owned it since the 1980's. Management is good, it's not terribly cyclical, you can understand the product Coke sells. Its obvious. Not going to see a lot of new challengers to Coke either. He prefers a management team that is very careful about watching costs. He himself is a zillionaire who lives in a modest sized house and whose only luxury is his private jet. When he had his first baby, he emptied a drawer out of his dresser, and had the baby sleep in the empty drawer. Yes he had money but was too cheap to buy a crib. I can relate.
So, then what does he look for in terms of VALUING a stock. That part is trickier, but it's some Graham & Dodd value ideas, particularly, buying stocks that are beaten up and hated. A Graham & Dodd phrase is "margin of safety" meaning that you should only buy stocks when they are 20% below their intrinsic value, a phrase often used by both G&D investors and Buffett.
As far as beaten up stocks, he once wrote that a stock that is down 25% is far less risky than one that has risen 25%. He is clearly not a momentum investor, and neither am I. To give a quick example, say a growth stock trades at 30x earnings. The problem is, when that stock eventually MISSES its EPS forecast (and eventually they all do), not only is the EPS lower, but then its P/E ratio goes lower too. It's a double whammy.
Say that XYZ growth stock did $1 in EPS, and traded at $30. That's a 30x P/E ratio. Then if it did only 0.90 in EPS, and traded to 25x earnings, then it's going to get smoked from $30 a share to $22.50 a share. That's down 25%.
Look at FFIV last month. It fell almost 25% in one day when it missed numbers, and still trades at 25x forward earnings, 50x trailing earnings. That is a risky stock. Good luck owning that one.
So, now lets look at some of the financial items that Buffet talks about: ROEs and high FCF yields. If you use P/E ratios a lot, then you need to understand that P/Es are often manipulated. Because earnings are manipulated. Buffett talks about this in his letter, and I focus constantly on cash earnings. You HAVE to always focus on cash. I won't get into too much of the accounting here, but one of the first things I do is look at cash Capital Expenditures (Capex), and compare it to Depreciation & Amortization (D&A). If D&A is much lower than Capex, then you need to figure out why. Because Capex is the cash, and D&A can be whatever the company wants it to be.
APPLYING BUFFET METHODOLOGY TO CISCO
So, let's look at Cisco, a hated stock that trades poorly today and so far my worst investment this year. So, first of all, its a beaten up stock. Good. Its returns on equity are 17+%. Good. Its per share earnings have grown 14% over the past 3 years. That is through 2008 and our Great Recession. Not great but not bad. Revenue, up 14% in that time.
Cash: It's capex per year is around $1.3BB. It's D&A is over $2BB however. That means that its generating a ton of cash relative to its reported EPS. Specifically trailing 12 month reported EPS is $1.36, but cash EPS is more like $1.50. Not only that, but CSCO has $4.50 per share in existing cash on the balance sheet. They could pay the shareholders this cash and nothing would change with the business. So net the $4.50 against the share price today (18.60), and you get $14.10 per share.
Take the real cash earnings of $1.50 per share and divides it into the share price net of cash. So, $1.50 divided by $14.10. That is a cash yield of 10.6% today. Not bad.
Now let's look at the stock like Buffet would, that he will own it forever. Instead of forever though, lets look 6 years down the road to pick a number. Finally, lets assume EPS never grows at all. Where are you creating this stock?
|EPS / yr||$ 1.50|
|Cash/ share||$ 9.00|
|Cash existing||$ 4.50|
|cash per share total||$ 13.50|
|Stock today||$ 18.60|
|creatig stock||$ 5.10|
|EPS in 6 yrs||$ 1.50|
3.4x! So, if CSCO does FLAT earnings for 6 years, in that time you will have generated $13.50 per share in cash on an $18.60 stock. That means you are only paying about $5 a share for this stock a few years down the road. For this stock to be flat in 6 years on flat earnings, means that it would have to trade at 3.4x earnings! Thats a 29% FCF yield. People really hate this stock. How can you lose? There is a zero chance it will trade at 3.4x P/E in 6 years. It can only be higher than today. (taken further, in 10 years, the company will have almost $20 per share just in cash, higher than the stock price).
This shows the power of compounding, even on a flat, mature business. The key is purchasing it at reasonable valuations. Likely this company will be a mature business in 6 years too, but let's now assume EPS grows modestly at 3% per year. That is at least the rate of population growth. Then in 6 years EPS is $1.79. If it trades at 12x earnings, a very modest multiple, then it will trade at $35 per share. That is up 88% in 6 years. That's my minimum target.
The "free option" is that they grow EPS by 7% per year. Not that aggressive, historically its been much higher. And let's use a 15x multiple, which is historically the big cap average. $2.25 in EPS X 15 is $47 a share including the cash, up 154% in 6 years.
This is why I buy low P/E stocks that have nice ROEs. As long as the business can remain stable, you can generate very large risk-adjusted returns. Markets aren't always saavy. In Cisco's case, I believe that investors see CSCO doing $1.36 in EPS, and divides the $18.60 by that to get a 14x P/E multiple. Which isn't seemingly cheap. But I think the market is ignoring cash on the balance sheet, and too short term focused to see the value here longer term.
You also have to understand the phenomenom that this stock is being tranferred from growth oriented investors/funds, to value investors. Personally, I don't get the distinction. Stocks are either OVERVALUED or UNDERVALUED. Growth mutual funds? I mean, some growth stocks are cheap, and some are expensive. But technically its a difficult transition for any equity to make.
I cannot, nor can anyone for that matter, know where CSCO will trade next week or next quarter. Cisco got blasted this year on weak guidance on their February call. They beat their bottom line number, but nobody cared. Sales growth is "only" 6%. Margins are contracting offsetting sales growth, so EPS growth was flat. Yet they still generated tons of cash. Cash will keep flowing into the company. That is key.
Is Juniper making some headway against Cisco? Yes, perhaps. But JNPR trades at 37x earnings. That's a 2.7% FCF yield. Who is happy with that? They have to grow very rapidly to catch up with that multiple. This is a momentum stock. When it cracks, it will crack hard. Cisco dominates the router and switching universe, and internet usage isn't going down. I can be reasonably assured that in 5-6 years, sales will be higher than today. This isn't the horse carriage industry.
WHY ENTRY POINT MATTERS
So, why is Cisco flat after 10 years when its EPS more than quadrupled in that time? Because it traded at 72x forward earnings in 2002. The stock was at $18.10 as of year end 2001, and it did $0.25 in EPS in 2002. 72x is insane. Earnings in fact doubled in 2003 to $0.50 a share, but its multiple fell to 26x, so the stock fell by 30% that year! The gradual degradation in P/E ratios kept the stock flat since 2003.
I think if we assume limited to no growth in Cisco though over the next 6 years, this stock will perform very well. Really, it's not a tough bet to make. Just give it some time.
Here is the link to Berkshire's annual letter: