So I explained in my most recent post (Buffett Letter 2012) on Berkshire Hathaway (BRK) why investments per share is not worth investment per share to me. I know this makes no sense to many, and even Buffett would say it makes no sense. Cash is worth what it’s worth. No more, no less.
I don’t have a problem with that, really. But I just have another way to look at it, so I thought I’d clarify a little bit more. Someone posted a comment that I should value investments at market value, and I responded there but then realized I should make my response a full post. I know there have been debates about this all over the internet for years.
So anyway, here are my thoughts.
Investments are Often Worth Market Value
First of all, investments are worth their market value if they are realizable. If it can be distributed to shareholders in some way (spin-off, liquidated and cash distributed etc.) without disrupting the business operations, then I believe you can value it at market (less taxes or whatever adjustments that need to be made).
On the other hand, if the investments are part of a business, like in an insurance company, then this is not freely distributable, and therefore it may not be worth market value (not to mention that float becomes an obligation on liquidation).
To keep things really simple, I’ll talk about a hypothetical insurance company instead of plugging in the real figures for BRK. I am going to make up all of these figures so bear with me.
Hypothetical Insurance Company: Berkaway Hathshire
First of all, let’s assume that this amazing insurance company, Berkaway, has an incredible underwriting staff that always breaks even (at least) in the underwriting operations. Let’s say that it’s pretty much a sure thing that the cost of float will be free.
Second, let’s assume that the investment leverage is 2.5x (much higher than BRK), and this company invests it’s float in only fixed income securities. After-tax return on fixed income securities these days come to around 2% (Don’t argue! Let’s just say it is true).
Let’s also say that the shareholders equity of Berkaway is $1 million.
So here are the figures:
Shareholders equity: $ 1 million
Float: $ 1.5 million
Investments: $ 2.5 million (2.5x investment leverage)
Net earnings: $ 50,000
This is what Berkaway looks like. You see that the ROE comes to 5% despite 2.5x investment leverage.
Now, this is what we are arguing about: What is the value of this insurance company?
If you believe that an insurance company with zero cost float is worth the investments it owns, then you are saying that Berkaway is worth $2.5 million.
OK. No problem. That’s one way to look at it.
Some say that the investments is worth market value because that is what you can get if you sell it. But does the $2.5 million really represent liquidation value? Let’s see what happens if you sold all the investments, paid back the float and distributed the rest to shareholders. What do you get? Exactly. You get $1 million, not $2.5 million. In liquidation, the float becomes an obligation even if it’s as good as equity in a going concern. That’s the paradox of this situation (like trying to catch your own thumb); float is as good as equity and investments are worth market value, but if investments are worth market value in liquidation, then float is not equity anymore).
Here is how an equity investor might look at it. I don’t want to get into theoretical stuff too much, but let’s just say that the cost of equity is 10%. In other words, when investors invest in stocks, they typically want to earn around 10%.
If that is the case, then Berkaway is clearly not worth $2.5 million.
As is common in valuing financial companies, the usual way to look at this (and I admit the usual way is not always the right way) is that if a financial company can’t earn 10% ROE, then it’s not worth book value, and if it can earn more than 10%, then it’s worth more than book value.
Buffett Agrees with This
So before we dismiss this notion that firms that earn an ROE below 10% isn’t worth book value as being silly, let’s think about what Warrren Buffett himself just said on CNBC the other day.
In talking about banks, someone asked him about the cheap banks; banks that trade for less than tangible book. Wells Fargo trades above book value. Buffett said that book value doesn’t matter in valuing banks, it’s the earnings that count. Now, that sounds odd coming from Buffett who advocates ROE as an important measure of capital efficiency or management competence.
What I realize now when he said that is that he just means that looking at P/B ratios is not that meaningful in evaluating banks.
He clarified that by saying that if a bank can earn return on tangible assets above 1.0%, then it can trade above tangible book value. If it can’t earn 1.0% on tangible assets, then it is worth less than tangible book value. Banks like Citigroup have ROA below 1% so isn’t worth more than tangible book.
By the way, I think Buffett uses 10x leverage for a typical bank, so 1% ROA translates into 10% ROE.
So he is saying the same thing I am saying about financials: If a financial can earn an ROE above 10%, it is worth more than book, and if it can’t, then it’s worth less than book.
Another way of saying that is that Buffett thinks the cost of equity for financial companies is around 10% (But don’t use that phrase, cost of equity, in front of Buffett!).
Back to Berkaway Hathshire
So, going back to Berkaway, the ROE in the above example would imply that it is only worth 50% of book value. On a 5% ROE, you have to pay 50% of book to make a 10% return. Book value of Berkaway was $1 million, so it’s only actually worth $500,000 (at 50% of book).
So how does that compare to total investments? Total investments are $2.5 million, so at $500,000, Berkaway is actually only worth 20% of total investments.
Other Insurance Companies
So if you still believe that BRK’s investments per share are worth the total value, then why not look at other insurance companies? I would imagine that other insurance companies are very cheap too using this metric (investments per share of Markel, for example, far exceeds it’s share price).
The common argument (which is fair) is that BRK doesn’t lose money in underwriting (unlike most other insurance companies). In fact, it has earned $18 billion in the last ten years or some such thing. I don’t know if I would want to bake that into any valuation (opinion here differs, but I don’t have a strong feeling either way. I just sort of not include it. All valuation measures to me are just ballpark things to think about, not concrete, absolute things).
But underwriting profits and losses can easily be incorporated in valuations. If cost of float is positive for some companies, you can just deduct from the valuation of the company (if it tends to lose, on average, $1 billion a year, just knock off $10 billion from the valuation). Conversely, if a company has a negative cost of float, then just capitalize that (if it tends to earn $1 billion in underwriting profits over time, then just add $10 billion to the valuation).
I don’t think there is a need to value one insurance company at investments per share because they have a zero or negative cost of float, and then value every other insurance company on the planet at book value or according to ROE.
That sort of seems unreasonable to me.
So, either look at BRK like other insurance companies (using book value, ROE etc…) or look at the other insurance companies using investments per share (and then making adjustments for underwriting losses/cost of float etc.).
I don’t think everything should be valued the same way, but in this case, I think it’s reasonable as it’s a pretty straightforward model we are talking about (ROE, P/B ratios etc…).
But anyway, this is just my opinion. I’m just clarifying my thoughts on the subject. I know that the opinions on this stuff differs dramatically and that’s totally fine.