Today, KCLau.com has 2 online courses on Growth Investing: Growth Vault and Value Masters.
I create Growth Vault with KC Lau while Value Masters is created by KC Lau and Peter Lim. The syllabus presented are similar in principles and values. We advocate business-like investing and impart skill sets such as accounting, valuation and portfolio management. However, as the three of us are different individuals, the way we look at the accounts, the choices and methods we use to value a stock and how we wish to construct our respective portfolios are different.
Think of it this way – Investing Is Like Cooking Egg Fried Rice.
Note: Yup, I had my Egg Fried Rice at Uncle Rogers!
We would use more or less similar ingredients (eggs, rice, oil, soy sauce and spring onions) and kitchen utensils (wok) to cook our egg fried rice. But, our way of cooking can be different and so, this would cause our egg fried rice to vary (to some extent) in taste and texture. That is art and it expresses our uniqueness as different individuals.
Here, I’ll attempt to express such “art and uniqueness” with Berkshire Hathaway, Inc (BRK). This article will illustrate the choices of tools used to value BRK and the thought-process behind such choices. Of which, you can choose which of the styles of valuation you prefer to adopt when you are assessing BRK or similar stocks for investing.
Introduction to BRK
BRK is managed by Warren E. Buffett, its Chairman. BRK runs a few insurance companies such as GEICO, Berkshire Hathaway Primary Group, and Berkshire Hathaway Reinsurance Group to raise capital known as “insurance float”. BRK invests these insurance floats to own a collection of businesses involved in the railroad, energy, manufacturing, services, and retail industries and as well as shares of public-listed companies such as Apple, Bank of America, Coca-Cola and so on and so forth.
Essentially, BRK is a holding company with a huge diversified portfolio of businesses.
Created by ChatGPT. Fuiyoh!
Using P/E Ratio
P/E Ratio is a valuation tool that is based on earnings.
I use P/E Ratio as an investor as my focus is on income productivity. My aim is to know if BRK is able to produce consistent growth in earnings from its portfolio of businesses over time. Such an ability is assessed by its financial results in the last 10 years. In that period, if a stock had grown its earnings consistently, I would proceed to valuing it with P/E Ratio. However, if the stock failed to deliver such consistent growth in earnings, I would dismiss it. After all, why would I invest in it, especially when the stock couldn’t produce earnings to its shareholders?
BRK’s Actual Earnings
Normally, I would first check the actual earnings of a stock before valuing it. In the case for BRK, I found BRK to have reported volatile and unpredictable actual earnings as follows:
Source: BRK
There are huge swings in its actual earnings in 2017-2023. It made US$ 44.9 billion in 2017 and subsequently, it reported US$ 4.0 billion in earnings in 2018 (92% drop from 2017). Then, BRK’s earnings increased to US$ 81.4 billion in 2019 (20X 2018 earnings) before reporting a decline to US$ 42.5 billion (almost 50% drop) in earnings in 2020.
Imagine assessing an apartment for investment where it could generate $10k in rental income in Year 1, $50k in Year 2, $5k in Year 3, and $20k in Year 4 and so. How would you estimate rental yield for this property? It’s almost impossible to do so. Similarly, the “huge swings” in earnings of BRK had made it impractical to use actual earnings to calculate P/E Ratio.
Why the Huge Swings and How to Overcome It?
The “huge swings” in BRK’s actual earnings is caused mainly by its obligation to report “gains or losses from its investments and derivative contracts”. Predominantly, these are unrealised gains or losses from BRK’s equity investments like shares of Apple, Bank of America, Coca-Cola, and so on.
Source: BRK
Take BRK’s equity investment in Apple as an example. In 2021, Apple’s shares had increased to US$ 170+ from US$ 130+. BRK held on and reported an unrealised gain of US$ 40+ a share. In 2022, Apple’s shares tumbled from US$ 170+ to US$ 130+. Once again, BRK held on and so, in its financial report for 2022, BRK recorded an unrealised loss of US$ 40+ a share.
As quoted by Buffett in BRK’s Annual Report 2017:
“The value of these holdings (referring to its marketable stocks) can easily swing US$ 10 billion or more within a quarterly reporting period. Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe its operating performance. For analytical purposes, Berkshire’s “bottom-line” will be useless.”
What are Truly Important Numbers?
To investors, “truly important numbers” are earnings produced from BRK’s businesses excluding the one-offs, non-recurrings and unrealised gains or losses from its stockholdings over the short term. Fortunately, BRK’s annual and quarterly reports provide a breakdown of the sources of the company’s earnings. It allows us to make adjustments by only focusing on BRK’s truly important numbers.
Source: BRK’s Annual Report 2023 (Page K35)
From such adjustments, the “truly important numbers” that can be used to assess BRK’s income generating ability is as follows:
Source: BRK
With these “adjusted earnings” figures, we can compute BRK’s adjusted earnings per share and subsequently, value its shares with P/E Ratio. In this manner, in 2023, I would value BRK, based on its ability to generate US$ 35.2 billion in adjusted earnings for that year. My valuation on BRK would be adjusted based on its latest adjusted earnings for the last 12 months. That’s my choice or preferred method of valuing BRK.
How about KC Lau and Peter Lim?
Now, we switch our focus to Value Masters.
Our similarity lies in acknowledging the “huge swings”. But, our differences lie in how we want to work around it. For me, I’ll calculate its P/E Ratio with its adjusted earning figures. As for them, I learnt that they opted to value BRK with P/B Ratio.
P/B Ratio is a valuation tool based on a stock’s book value or net assets per share.
Net assets is the net worth of a stock where we subtract all liabilities from all assets that it owns.
Let’s say I own a company. It owns $2 million in total assets and owes $1 million in total debt. As such, the company’s net assets is $1 million. The company issues 1 million shares. Thus, its net assets per share would be $1. Supposedly, you are an investor and wish to own a 20% interest in my company. How much would you invest to effectively own the $200,000 in net assets of the company (20% x $1 million)?
And, how much am I willing to sell the 20% stake in my company to you?
Well, if the company’s assets are solid with strong growth potential, I wouldn’t sell the 20% stake to you for $200,000. I would mark it up. Let’s say, I’m offering to you at a price of $300,000. That would be a 50% premium of my company’s net assets. This equals to a P/B Ratio of 1.5.
However, if the company is not well-run and incurring losses, I could offer a discount for the 20% stake in my company. This is so that the company can raise cash to stay afloat or be turnaround in business results. Let’s say, I’m offering to you at a price of $150,000. Such would amount to a 25% discount of my company’s net assets. This equals to a P/B Ratio of 0.75.
For KC Lau and Peter Lim, they value BRK in 2023 based on its net assets per share in 2023. It is more straightforward and less work as we can take BRK’s shareholders’ equity and just divide it with its latest number of shares to derive its net assets per share. Subsequently, all of us could just take BRK’s share price and divide it with its net assets per share to obtain its P/B Ratio.
Source: BRK’s Annual Report 2023 (Page K71)
Source: BRK’s Annual Report 2023 (Page K72)
Will There Be Any Difference in Decision Making?
The answer is yes.
This is because our choice of valuation tools (P/E or P/B) reflects how we measure success. For instance, I use P/E as I measure success in terms of long-term earnings growth. This means, as an investor, if I invest in BRK, I would view my investment to be a success if BRK could continue to deliver growth in its adjusted earnings for the long-term.
As for KC Lau and Peter Lim, I suppose their metric of success would be on BRK’s growth in net assets a share as they use P/B Ratio. It means, BRK is successful if it could continue to grow its shareholders’ equity over time.
Which is More Suitable to You?
There is really no need to choose. You can use anyone or both of the valuation tools on BRK.
Let me do a simple back test.
Here, I’ll calculate the annual return for investors who’d invested in BRK some 10 years ago and hold onto its shares till today. So, in 2013-2023, BRK had reported the following:
Adjusted Earnings per Share and net assets per share had grown at a faster pace than adjusted earnings and shareholders’ equity due to BRK’s continuous share buybacks in that period. So, if I choose to use P/E Ratio as a valuation tool, the CAGR that I would refer to is 9.67%. Whereas, if I choose to use P/B Ratio, the CAGR that I would use is 11.12%.
Back in 2013, BRK’s adjusted EPS was US$ 6.43 and its net assets a share was US$ 90.02. So here, let’s assume we could invest in BRK at sometime in 2014 at prices ranging as follows:
As I write (2024), BRK’s share price is US$ 468.40. So, in all the 6 prices above, be it the lowest at US$ 90.02 or the highest at US$ 192.90, we would achieve capital growth.
Typically, the rate of capital growth gravitates towards BRK’s growth in earnings or net assets. In this sense, the major drivers for return lies in the stock’s fundamental quality and the time period of our holdings.
The longer we hold at a higher compounding annual rate, the higher our returns.
Sure, valuation does impact returns. For instance, investors who buy BRK at P/E of 20 or P/B of 1.0 would definitely attain greater returns from others who buy BRK at P/E of 30 or P/B of 2.0. In that sense, make sure to put a cap on valuation ratios so that we avoid overpay for these shares in the market.
Summary
In short, let me offer a list of lessons from this discussion:
- There is a science and art to investing, just like cooking egg fried rice.
- Different investors would use different valuation tools differently.
- Focus on the “truly important numbers” when assessing BRK’s financial performance.
- Because of this, I calculate BRK’s P/E based on its adjusted earnings, not actual.
- The main drivers of returns are: earnings growth + duration of stockholdings.
- The return rate tends to gravitate towards a stock’s long-term CAGR of EPS.
- The minor driver of returns is valuation. Hence, try not to overpay for a good stock.
Here, if you intend to learn how to build a portfolio filled only with the top 1% corporations in the US, you may check out our free 1-Hour Online Webinar on Growth Investing as follows:
