Buffett is Right: Berkshire is Undervalued
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Warren Buffett announced last September that Berkshire Hathaway (NYSE: BRK-B) (NYSE: BRK-A) will be buying back its own stock if the price to book value ratio falls below 1.1. Buffett has never done something like that before, so he must have good reasons to believe that at those levels Berkshire is materially undervalued.
In fact, he provides a great explanation about book value and how to interpret it for valuation purposes in his letter to shareholders of 1983. Basically, the book value of a company is an accounting measure of shareholders' capital, but in order to know if that figure really represents the intrinsic or economic value of the business, investors need to analyze how productive that capital is:
Book value tells you what has been put in; intrinsic business value estimates what can be taken out. An analogy will suggest the difference.
Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously - from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value.
Some companies are worth much more than their book value, simply because they are better than average at generating returns with their book value. In his 1983 shareholder's letter Buffett explains why he thinks Berkshire is worth much more than what accounting figures reflect.
There are two main reasons for that. One of them is related to accounting rules, the GAAP – Generally Accepted Accounting Principles -- require common stocks held by insurance subsidiaries to be stated on the books at market value, but other stocks Berkshire owns are carried at the lower of aggregate cost or market, which obviously understates the real market value of investments that have risen exponentially through the years.
Second, Berkshire owned, and still owns, several businesses that are worth much more than their books when considering their true intrinsic value. A fantastic brand, a solid reputation among customers, or an outstanding management team are things that are not reflected in book value, yet they are tremendously important when analyzing a company and its ability to generate returns for shareholders.
When thinking about companies like Coca-Cola (NYSE: KO), it's quite clear that book value underestimates the real value of the company. The value of Coca-Cola cannot be reduced to its buildings, machines, and other easily quantifiable assets; the company owns the most valuable brand in the world according to Interbrand, and that's worth much more than what book value reflects.
One of Buffett's most noteworthy acquisitions in recent times is IBM (NYSE: IBM), which according to Interbrand is the second most valuable brand in the planet. In fact, Coca-Cola and IBM are the two largest positions in Berkshire's portfolio of listed stocks, representing nearly 21% and 18%, respectively. The two most valuable brands are the two biggest positions -- you don't need to be a genius to connect the dots.
Strong brands are just one example of a powerful competitive advantage, and that is something that's not reflected in the book value of companies. Berkshire is a collection of businesses with rock solid competitive advantages, so it's worth much more than what book value can express.
acardenal owns shares of IBM. The Motley Fool owns shares of Berkshire Hathaway, International Business Machines, and The Coca-Cola Company. Motley Fool newsletter services recommend Berkshire Hathaway and The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.