Valuing a conglomerate is difficult. Instead of a single operating business, conglomerates may have a range of subsidiaries that make it impossible to analyze using a single operating metric such as the P/E ratio.
Take Berkshire Hathaway, for example. It owns an insurance subsidiary, large investment portfolio, railroad, energy business, and has a massive cash pile. Putting a value on all these parts is tough to do holistically.
Which is why we like to use the sum-of-the-parts (SOTP) method to value a conglomerate. Using your valuation toolkit, you look at each individual part of the business, put an estimated value on it, and then add them back together again. Hence, the summing of the parts.
Berkshire Hathaway’s insurance subsidiaries have generated $23.5 billion in earnings over the last twelve months. This number has risen rapidly with the increase in interest rates in the United States, which helps the profit potential of an insurance operator.
Using a standard P/E of 20, this segment could be worth around $470 billion.
Next up, we have Berkshire Hathaway’s BNSF railway and Berkshire Hathaway Energy. Combined, these two companies generated $8.8 billion in operating earnings over the last twelve months. Assuming these low-growth operators deserve a P/E of 15, the segments could be worth around $132 billion to the stock.
Next, we have Berkshire Hathaway’s stock portfolio and cash pile. At the end of last quarter, Berkshire Hathaway’s cash pile (including fixed income securities) had grown to $336 billion. We can hold this cash at cost, there is no earnings multiple to apply to it. However, the company is earnings over $10 billion in net interest income by just taking this cash and investing in U.S. treasury bills.
Last we have the equity portfolio, which was valued at around $300 billion at the end of last quarter if you include its equity method investments. While Warren Buffett does have a strong investment track record, let’s assume for this exercise that these equity investments can be held at cost.
So, how do we perform a SOTP valuation? Just add up all our estimates of what the subsidiaries are worth. Summing all four together (which actually excludes a few smaller items, it should be noted) and you get an intrinsic value of $1.2 trillion, which is below Berkshire Hathaway’s current market capitalization of $1 trillion.
The difficulty of the SOTP model is that it can require the usage of varying valuation methods, which can take a lot of time. But they can provide really strong stock results when run correctly, which is why
Everything comes together with an able management team. When evaluating a conglomerate, the importance of management cannot be understated. It doesn’t matter if a stock is cheap on the SOTP method if a management team doesn’t take advantage of it. Buffett and Berkshire Hathaway have done so in the past by repurchasing stock when shares look undervalued.
So, there you have it, the SOTP method for evaluating a conglomerate. It is not a straightforwad method. For each company, you need to decide how to divide up the subsidiaries and what valuation method to use for each one. But on the whole, the concept is the same: value the parts and add them up to see what you think the company is worth.
If the stock is trading below your estimate of intrinsic value, it might be an opportunity to buy shares for your portfolio.
Valuing Conglomerates w/ Book Value Per Share (BVPS)
Book value per share is an overrated metric when looking at most businesses. But with conglomerates and financials, it can be a useful metric to value a stock.
In the olden days, value investing meant buying a company below book value, meaning a price-to-book (P/B) of less than 1. Book value is another term for shareholder’s equity and is calculated by subtracting the total liabilities from the total assets on a company’s balance sheet.
Essentially, book value is the liquidation value of a company. It is what the shareholders would receive if the company decided to stop operating, pay back its liabilities, sell its assets, and give the cash back to shareholders. Book value per share is simply this figure divided by the total outstanding shares.
Today, book value per share is less useful as a metric as stocks have moved towards capital-light business models. Is a software company with minimal physical assets on the balance sheet overvalued because it trades at a P/B of 15? Not necessarily. You shouldn’t keep yourself from buying a company just because it has an expensive P/B. Only a few types of companies should be valued in this way.
You also have the rise of stock buybacks as a way to return capital to shareholders. Buying back stock above book value reduces book value per share, but can be an intelligent capital allocation decision if the stock is undervalued based on its earnings or cash flows.
For example, Apple’s P/B has mooned to 60 because of its consistent share repurchase program. In fact, it has been a long time since Apple has traded below a P/B of 1. If you were a value investor in the classical sense, the rigidity of only buying a stock below a P/B of 1 would keep you out of a monster stock winner for your portfolio.
But when should you use book value? Do so when evaluating two types of companies:
- Banks/financials
- Conglomerates
Conglomerates can own pieces of businesses, a stock portfolio, or hold outstanding loans as assets on the balance sheet. It will also be adding goodwill to the balance sheet when making acquisitions, which adds to its asset total. Book value per share can help gauge how fast management is growing shareholder value with its acquisition strategy.
A financial company — which can be a lender, bank, or insurance operator — makes money by taking on liabilities and then buying assets to earn a spread on the cost of these liabilities. For example, a bank will take a bunch of deposits, which are liabilities. Using these deposits, it will make loans, which are assets.
The more profitable its loan portfolio, the faster its assets will grow. Therefore, you can use book value per share as an operating metric for how successful a bank is. If it is growing quickly, the company is doing well. But if it is declining, the banking business is unprofitable.
Markel and Berkshire Hathaway are conglomerates and financials, given their insurance operations and acquisition strategies. For the most part, book value per share can give a first estimate of the value of the business, while historical book value per share can help understand how fast the conglomerate is growing its value for shareholders.
Markel’s book value per share is close to $1,300. Book value per share has grown at an 11% rate since 2004. That shows the company’s consistent value creation for shareholders.
