valuing berkshire

Berkshire Hathaway is priced by the market at $356 b; and it is now the seventh largest company by market-cap in the US. Amazon and Facebook just went ahead of Berkshire recently. It took Facebook about 12 years and for Berkshire more than 50 years to reach where they are today is another matter. Facebook which went public only 4 years ago is priced at high multiples of its earnings. So growth it is that the market is considering when pricing; low growth for Berkshire and high growth for Facebook.

Berkshire is a conglomerate which acts as a holding company of several diversified businesses. Each business is run by an independent CEO without much interference from the head office. It has an extraordinary business model where there aren't much of corporate meetings, forecasts or guidances. There is no smoothing of earnings either. What is earned in a quarter is what is actually reported. It is always a pleasure to read its annual letter to the shareholders. There is no question that Buffett and Munger have turned Berkshire into what it is today with the most contrarian approach possible to business and investing. 

Everyone is interested how Berkshire would perform post these two exceptional managers. More precisely, how it would reward its shareholders based on its current pricing? The class A share is trading at $216,000. Its class B shares are worth 1/1500 of class A in terms of cash flows, and are also traded in the market. Berkshire had 1.643 m shares of class A equivalent as of December 2015.

Valuing Berkshire is not easy. One has to value each business separately and add up to arrive at the value of the total business. Analysts do not want to get into that hassle. The easy way for them is to price the stock and call it value.

As much as Buffett likes to see Berkshire's stock price trade close to its book value, it is not the right value for the business. This is because Berkshire's operating businesses cannot be marked to market. It now has many capital-intensive businesses which probably should be valued much higher than book value. Therefore, book value of $155,501 per share for the company is actually not meaningful. 

At the very top level, Berkshire is an insurance company; and one of the best runs at that. Premiums received by insurance business are invested in its operating business for acquisitions. The operating business comprises several independent businesses. Premiums and excess cash from operating businesses are also invested in stock markets. Berkshire had an investment portfolio of $159,794 per share as of December 2015. Berkshire also makes underwriting profits consistently. 

Analysts price its stock by applying a multiple to its earnings. As per its 2015 annual report, pretax earnings per share from its operations was $12,304. If we apply a PE of 10, the price of operating business will be $123,040. Including investments, which are market to market, the price of the whole company comes to $282,834 per share (class A equivalent). It seems like there is an upside to its market price.

Since earnings accrue to the shareholders after tax, why should we use pretax earnings? Applying a tax rate of 35%, the after-tax operating earnings will be $7,998 per share. With the PE of 10, the operating business will be worth $79,980, and Berkshire will be priced at $239,774 per share. Still higher than its market price.

In 2015, Berkshire class A shares traded at a high price of $227,500 and a low price of $190,007. Let's consider only the high price and remove investments of $159,794 to arrive at the market price of its operating business of $67,706. This price has an implied PE of 8.47. I have not considered the low price because often the market has failed to recognize the value of its operating business altogether, which is illogical. This implied PE has been falling consistently over the last 10 years; it was 37.47 in 2000 and 4.29 in 2012. If we use the 5-year average implied PE of 8.22, the price of operating business will be $65,709 per share and including investments, Berkshire will be priced at $225,503. Again higher than its current market price, but not much.

How about its cash flows? Going forward if Berkshire is not going to be in acquisition spree, we can assume that its reinvestment requirements will be met by depreciation and other non-cash charges. If this assumption holds good, Berkshire's free cash flows will be equal to its earnings. If so, its free cash flows are going to be $7,998 per share in perpetuity without any growth and more if we assume some growth.

At an expected return of 8% and zero growth, the value of operating business will be $99,970 per share and including investments, Berkshire will be valued at $259,764. If we assume a growth rate of 2% in perpetuity, the value of Berkshire will be $295,753.

If we assume that Berkshire's reinvestment requirement will be a function of its return on equity and growth rate, the value of operating business will be $103,969 and Berkshire value will be $263,763 per share. I have assumed that Berkshire will be able to sustain return on equity of 8.50% and growth rate of 2% forever.

So we have a range of prices and values for Berkshire. Interesting part though is that all are above its current market price of $216,000. Both Buffett and Munger are probably right in their opinion about the future of Berkshire.

I would be surprised if Berkshire fails to achieve a moderate growth in the absence of its star managers. If it will not be a market-beating stock, it will also not be a market-beaten stock. 

motherson sumi, $18 billion and 20.90%

Motherson Sumi Systems Ltd is primarily in the business of manufacture of components to automotive original equipment manufacturers. It is owned by Samvardhana Motherson International Ltd (36.93%) and Sumitomo Wiring Systems Ltd, Japan (25.29%); Sehgal family owns 3.39%. 

The company operates through 93 subsidiaries, 11 joint ventures and 2 associates in 25 countries. It has manufacturing plants in India, Sri Lanka, Thailand, UAE, Australia, UK, Germany, Hungary, Portugal, Spain, France, Slovakia, China, South Korea, USA, Brazil, Mexico, Czech Republic, Japan, South Africa and Ireland. 

Samvardhana Motherson Automotive Systems Group BV, The Netherlands (SMRP BV) is a joint venture between the company (51%) and Samvardhana Motherson International Ltd (49%). SMRP BV operates through its subsidiaries, Samvardhana Motherson Reflectec (SMR, 98.50%) and Samvardhana Motherson Peguform (SMP, 100%).

Motherson Sumi had revenues of Rs.345 b in 2015, of which 85% was from outside of India. Its latest annual report for the year ended 31 March 2016 is not yet out. Revenues increased by 38.85% annually for the last 5 years and by 46% for the last 10 years. 

It earned operating profits of Rs.18.35 b and net profits of Rs.8.62 b in 2015. Growth in operating profits was phenomenal at 93.85% per annum in the last 5 years and 33% in the last 10 years. Net profits grew at 28.86% and 26.23% annually during the respective periods. 

Earnings per share in 2015 was Rs.9.78 which grew at 27.70% (last 5 years) and 24.89% (last 10 years). During the last 10 years, the company issued 35.21 m shares by way of conversion of foreign currency bonds and 4.42 m shares through merger with Sumi Motherson Innovative Engineering Ltd. Apart from these issues, all increase in earnings have accrued to the original shareholders. 

The company approved 4 bonus issues during the last 10-year period, because of which the number of shares of increased to 881.92 m. In June 2015, there was another bonus issue and consequently, the number of shares outstanding as of now stands at 1322.88 m. 

Let's get all this hullabaloo out of the way and come to the point. As of now, the market price of the stock is Rs.308.85 and has an implied PE of 47.37. Note that EPS of Rs.6.52 is recalculated based on 2015 earnings but adjusted for bonus shares issued subsequently. 

Targets
Management has set some bold targets for the next 5 years, especially after considering the fact that their previous 5-year targets were easily met.

Revenues

How much do the investors stand to gain if the company is able to achieve these targets? Revenues would be Rs.1206 b in 2020 assuming a constant rupee-dollar exchange rate of Rs.67.

Margins

Both operating profit and net profit margins have been falling over the years. Average operating profit margin during the last 5 and 10 years is lower than 5%. In 2015, they were 5.31% and 2.49%.

If we consider operating margin of 5.50% and net margin of 2.50% as sustainable, operating profit would be Rs.66.33 b and net earnings would be Rs.30.15 b in 2020.

Capital efficiency

The next target for management is to achieve a return on capital of 40% in 2020. This is a quite adventurous if we consider the company's past heroics on this front.

It is not clear whether it is a pretax or after-tax return on capital. I do not like to measure return on capital before tax. However, if we do it for Motherson Sumi, the capital requirement in terms of reinvestment to achieve those target revenues appears to be overly courageous as we can see soon. So I will stick to the before tax target. 

Operating capital in 2015 was Rs.75.12 b without considering the effect of lease debt. Operating capital required to achieve 40% return on capital considering operating profits before tax would be Rs.165.82 b in 2020. 

Reinvestment required as measured by sales-to-capital in the past has been improving.

In 2015, revenues of Rs.4.60 were generated from a rupee of capital. With Rs.165.82 b capital required to achieve Rs.1206 b revenues in 2020, it increases to 7.27. This is already efficient enough. If we consider after-tax return on capital, the sales-to-capital increases to 11.19. This is what I called courageous. As I noted, I will stick to the before tax target. 

Reinvestment

Reinvestment of Rs.90.71 b would be required in the next 5 years to achieve the targeted revenues. Considering the fact that Motherson Sumi has not much diluted its per-share earnings in the past, we would expect to see the same trend to continue. I also assume that all reinvestment would be funded by new debt. 

Earnings per share and market pricing

Keeping the number of shares outstanding constant at 1322.88 m, earnings per share in 2020 would be Rs.22.79. 

I check PE multiples only as a matter of interest, but not necessarily for investment valuation purposes. I prefer to consider it in combination with DCF analysis. Since this analysis is to see where management is able to take its shareholders, I will use PE for coming up with a market price.

There is a range of PE at which the stock has been priced by the market in the past. The average high-PE in the last 5 years was 35.66 and the average low-PE was 19.35. Increase of EPS at 28.44% annually in the next 5 years is a big deal, and market could price the stock at higher multiples. 

I have excluded all cash flows remaining after payment of dividends for the purpose of this analysis, and have assumed that this cash would lead to higher PE multiple.  

If we consider a PE of 35, the market price would be Rs.797.69 in 2020. That is an expected return of about 20.90% per annum over the 5-year period. Dividends are additional cash and would increase the rate of return. Take it if you believe it. 

Debt to capital

The debt ratio as of 2015 was 19.14% in market value terms. This would change to 12.03% in 2020. This is after considering lease debt of Rs.2.29 b. The remarkable increase in return on capital would be the reason for this comfortable position.

The catch

Lofty targets set by management would be a challenge. If those are not met, revenues and earnings would fall; in addition, the PE multiple would fall too. Isn't this usually the catch with any firm?

The sensitivity of these values is captured below.

If revenues in 2020 are $10 b instead of $18 b, which is a growth rate of 14.14% per annum, the rate of return before dividends would be 2.43%.

If return on capital is at 25% instead of 40%, the expected return would not change; however, debt ratio will increase.

My guess on the future would be as good as yours. Heck, all wrong.

a or b, which is more valuable

Recently there was a news story. But before we get to that let's do a small exercise. We have some numbers from two firms in their respective, although unrelated, fields. 

Which firm do you think is more valuable? May be we don't have complete information about their business, prospects and so forth. Yet, B should strike as more valuable, especially when we consider that B is in a stable, not declining, business. 

As of now, the market value of equity of A is $347 b and that of B is $360 b. How did that happen?

Earnings are not better indicators of business value compared to cash flows. So let's check out the cash flows. 

In the last three years, average cash flows to equity of A was $3.74 b while that of B was $20.28 b. Note that although these numbers have been taken from Yahoo Finance (for investment purposes I prefer to pick them from financial statements directly), they may not be far off. So let's move with them.

Has the market gone crazy? More often markets remain rational, but not always. Should we consider that this is one of those times? 

May be A is into some sunshine business on the verge of disrupting the industry. May be A has much higher growth rate than B. May be. However, my aim is to find out under what circumstances should higher value for A be justified.

Let's assume that our expected return from equity is 10%, and also assume that cash flows are perpetual. 

To get to their current market value, cash flows of A will have to grow at 8.92% annually, and those of B will have to grow at 4.36% in perpetuity. 

If we lower the expected return to 8%, the growth rates for A will be 6.92% and for B 2.36%. 

Even when we consider that it is a global market, not restricted to the US, growth rates of A appear to be stretched compared to B.

May be there is some time for A to reach stable period of growth. Let's assume that cash flows to firm go to equity holders in the absence of debt. What the heck is there to assume anyway?

I know that equating firm cash flows to equity is a bad idea. Let's correct it. If we assume two growth periods for A, free cash flows to equity to come to $7 b. This is how we get it: present value of average cash flows to equity of $3.74 b growing at 15% in the next 10 years at 8% cost of equity is $7 b, which is close to $7.3 b. A had revenues of $107 b in 2015; if they grow at 15% in the next 10 years, they would be $433 b in year 10. Walmart had revenues of $482 b in 2015. A would also require adequate reinvestment to achieve the required growth rate.

Even when we consider free cash flows to equity of $7.33 b, A will have to grow them at 5.89% annually forever. Can A pull it off? Time will tell. For the moment though A has a story to tell for those who want to hear.

Is growth rate higher than 15% in the next 10 years sustainable for A? Its revenues grew annually at 29% in the last 5 years. What the heck, if we assume 25% growth rate in the next 10 years? This is how it would look:

Finally, we did it. If A grows at 25% in the next 10 years, and then at 3.34% in perpetuity, it could be valued at $347 b. For that A will have to achieve revenues of $996 b and free cash flows of 35 b in year 10. Is that possible? Time will tell. All I know is that growth does not come free; it needs reinvestment to sustain it, which we have not considered explicitly.

Market value of A's equity has been growing since long. 

I have written about it earlier and before. You know what, I like numbers more than stories, earnings more than numbers and cash more than earnings. So I still ask Amazon, where's the cash? Or should I put that question across to the market?