Book value is a measure of a company’s net worth, so it may come as a surprise that Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) is trading for a premium of around 50% to its book value. However, if you understand what book value is and its shortcomings, this discrepancy makes perfect sense. With that in mind, here’s why Berkshire is worth more than its book value would suggest.
What is book value?
Also referred to as a company’s net worth, book value can be easily calculated from a company’s balance sheet. Book value is the total value of the company’s assets minus its outstanding debts. Dividing the book value by the number of shares outstanding yields the book value per share, which investors often use to compare with the company’s stock price, known as the price-to-book ratio. .
Theoretically, book value is the amount of money a business would have left if it closed its doors, sold all of its assets, and paid off all of its debts. Granted, book value isn’t perfect – some of the items on a balance sheet don’t perfectly reflect the value of assets, such as depreciation allowances. And many intangibles are difficult, if not impossible, to value accurately.
It is not uncommon for businesses to be worth more than book value
Book value is a commonly used measure in value investing because it tends to provide a benchmark of what a company is “worth”. For example, if you can buy a company’s stock for 80% of its book value, that may be a smart value play.
However, a company’s profitability and future potential are also factored into the share price, so it is not uncommon for shares to trade at a price significantly above book value. Wells Fargofor example, has always been one of the most efficient and profitable banks, such that it is trading at 1.46 times its book value at the time of writing.
In addition, book value does not accurately reflect certain types of intangible assets, such as intellectual property. As a result, companies that rely heavily on intellectual property to manufacture products often trade for many times book value and can still be attractive investments. I consider Apple to be an extremely cheap stock by most valuation methods, yet the company trades at around 6.3 times its book value precisely because of shortcomings in the method of calculating book value.
Berkshire’s book value and why the company is worth more
At the end of 2016, Berkshire’s book value per share (Class A shares) was $172,108, while the stock is trading at $265,800 as I write this, a premium of around 54 %. The simple explanation is that the difference is the result of Berkshire’s business model which focuses on acquiring entire companies.
Here is the (slightly) longer version. Until the 1990s, Berkshire’s book value and its stock price were about the same. Indeed, Berkshire’s main objective was to invest in marketable securities (stocks), which are regularly revalued when included in the company’s book value.
On the other hand, the accounting rules for investees are very different. As CEO Warren Buffett explained in his last letter to shareholders: “The accounting of the companies we own requires that the book value of ‘losers’ be written down when their failures become apparent. The “winners”, on the other hand, are never upgraded upwards. »
In other words, Berkshire’s book value suffers every time it finds it has overpaid a company. However, when it becomes apparent that Berkshire has underpaid for a company, its book value is not adjusted upwards. Over time, this produced a significant discrepancy between the company’s share price and book value.
It’s also worth mentioning that Berkshire’s book value and its stock price don’t always move in the same direction or with a similar magnitude. For example, in 2016, Berkshire’s book value increased by 10.7% while its share price increased by more than double that rate. Conversely, Berkshire’s book value rose 6.4% in 2015, but its share price actually fell 12.5%.
Over time, Berkshire’s stock price has risen faster than its book value, which makes sense, given the explanation for why Berkshire is worth more than the book. Over the 52-year period from 1965 to the end of 2016, Berkshire’s book value grew at an annualized rate of 19%, while its share price rose at an even more impressive rate of 20%. 8%.
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