Companies

Believing completely in my valuation model and approach, I now rarely read about “the world’s greatest living investor” Warren Buffett and his legendary investment company Berkshire Hathaway.

But perhaps I should pay more attention? Because it seems that each deal or media appearance is worthy of further scrutiny and the well-reported $US26 billion buyout of railway company Burlington Northern Santa Fe is no exception.

This largest-ever Buffett investment, combined with a strong Australian dollar and a controversial 50-for-1 split of the Berkshire B class shares (which lowers their share price from $US3325 per share to about $US67) makes a back-of-the-envelope valuation of Berkshire Hathaway an interesting exercise.

So, with enthusiasm, I offer my value of Berkshire Hathaway.

The average annual compounded rate of growth in Berkshire’s book value – its equity – is equal to its return on equity. We can thus approximate the true rate of return on equity for Berkshire by examining the actual rate of change in book value.

Post acquisition, intrinsic value will not increase by the attractive rate it has in the past, unless returns on equity of the past can be maintained as the book value of the company continues to expand. The law of large numbers applies here. It is relatively easy to achieve 20% on $1 million – I can think of two stocks right now that will do that for you over the next two years (and I’ll be writing about these companies in the coming weeks for Alan Kohler’s Eureka Report), but achieving 20% on the $US118 billion of book value Berkshire has today will be a lot more difficult. That is why Buffett needs elephants, and elephants at the right price.

In the four or five decades since 1964, book value has grown by a compounded rate of 20.1 percent – a startling effort – and because of the high rate of return on equity that it reflects, each dollar retained has created more than a dollar of long-term market value. That is why the share price of Class A shares now stands at over $US100,000 per share.

But Buffett has always warned that, in the future, the massive amounts of capital at his disposal means that while you and I have a universe of thousands of companies that can have a material positive impact on our wealth, his investment universe is a few hundred at best. He needs elephants, and if he doesn’t get them his return on equity must inevitably fall. Recently return on equity has averaged 7.5%.

In valuing the shares, there is the A-class, which trade at over $US100,000 each, and the B-class, to which I referred earlier. The simplest way for me to convey the value is to estimate an A-Class equivalent valuation. And to cut to the chase, the value – based on an assumed 12% return on equity (optimistic perhaps) – is approximately $US108,000.

Given that the B-class shares, as an investment, are 1/30th the value and are about to be split 50-for-1, the value of them based on the optimistic return on equity is $US72. If, however, you assume that Berkshire Hathaway continues to achieve the average 7.5% returns on equity it has recently, the valuation falls dramatically because Buffett is retaining profits and generating a rate of return on them that is less than I can achieve elsewhere.

In such circumstances, the only price to pay is a discount to the forecast $US82,000 per-share book value of the company – about $35 per post-split B-class share.

By Roger Montgomery, 13 November 2009

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On Richard Goncalve’s Market Moves show on the Sky Business Channel last week I mentioned I would estimate a value for Fortescue Metals Group (ASX:FMG). Let me be the first to say that, like IT businesses, companies in the resources sector are notoriously difficult to value. This is not because they are in a fast changing industry whose long term economics are difficult to predict, but because the economics are based on commodity prices that change daily and whose prediction is almost impossible.

Having said that I should offer a caveat; Buffett’s announcement that he is buying the railroad operator Burlington/Santa Fe in a $44 billion deal – his biggest ever – suggests he truly believes that fuel prices are going up a lot. Indeed while higher diesel prices will raise the costs of running trains, it will raise the cost of operating trucks over trains by a factor of four.

But I digress, FMG – based entirely on 2010 consensus analyst forecasts – is worth $1.90 to $2.00. Another caveat – consensus analysts predictions could be wrong.

By Roger Montgomery, 4 November 2009

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Paul from WA asks to value ServCorp.  Don’t get excited, I am not going to make a habit of doing this.

Management have delivered returns on equity in excess of 20% over the past five years. This is desirable given the amount of profits being retained to organically grow equity and fund its expansion plans. The balance sheet is strong with plenty of net cash and the business is generating high quality cash flows.

Because of the recent capital raising of circa $80m to fund an expansion program of around 100 floors, any valuation must contain a caveat that it is subject to the rate of return the company manages to achieve on the incremental equity.

So, watch the capital raising development closely. Up until recently, management has been content to slowly and organically growing the business via the reinvestment of profits to fund the roll out of new floors. I like this and the model appears to have worked, with around 67 floors being opened to date.

The capital raising signals a departure from SRV’s original approach. Management plan on opening ‘at least’ 100 new floors – that’s more than double the current level over the next three to four years.

As with any aggressive growth plan, scalable systems must exist particularly when growth of circa 150% in such a short period of time, needs to be managed.  Always a challenge.

Management believe that they will be able to enter into leases within A-grade properties and new markets at attractive rates, taking advantage of any recovery in economic activity.

If they can deliver returns commensurate with recently reported ROE levels, on a materially expanded equity base, investors should be handsomely rewarded. All bets are off if green shoots fail to germinate.  Remember Servcorp is a cyclical business.

So what is the value?  Without taking into account the profitability of the recent capital raising, the value is $2.39.  I wouldn’t pay much attention to this valuation because if the company can employ the capital it recently raised at previously recorded rates of return, the value is closer to the current price.

By Roger Montgomery, 22 October 2009

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On Your Money Your Call with Nina May on 24 September 2009 I promised to value Worley Parsons.

What is WOR worth? After running my ruler over the business’ historical fundamentals, I estimate WOR is currently valued at $27.44 (2010). The share price is $29.43, making it a little expensive at the moment.

But WOR is a business with attractive underlying long-term investment fundamentals, including an average return on equity of 23%, a modest net gearing level of 33% and bright prospects with ongoing demand for Australia’s resources.

This demand should underpin capital spending programs by our miners in the future and hence the need for engineering companies to continue servicing a market that has grown remarkably over the past 10 years.

WOR is one to add to your watchlist should a more rational share-price present itself.

By Roger Montgomery, 20 October 2009

Update 28 October, 2009

Please keep in mind that for WOR there is a very strong likelihood that the businesses future earnings will be materially impacted by the strong Australian dollar. 25% of Worley’s revenues come from Canada, 24% for the US and latin America, 15% from the Middle east / Asia and 11% from Europe and Africa.

Although many analysts and market commentators currently have concerns about the currency and the headwinds facing earnings, these have to be weighed up against the strong cash flows WOR is generating and the fact it is a leader in its sector globally. Also, a high oil price will be a positive. A high oil price makes previously uneconomical finds profitable and increases revenues for many firms which are already producing. More revenue equals bigger budgets for capital projects. Obviously. Saying this, consensus forecasts have fallen in recent days. This has led to a revision in my valuation to $26.08. This is by no means is a recommendation, merely a discussion about the strengths of the business and also its weaknesses in the face of a higher Australian dollar.

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This blog is for viewers of Nina May’s Your Money Your Call program on Sky Business Channel last week who requested a valuation for Lemarne Corporation Limited (LMC).

LMC’s history is a lumpy one. It is no JB Hi-Fi or The Reject Shop in terms of its economic performance. This makes the process of valuing the company more subjective.

ROE over the last 10 years has averaged 14%, varying between -1.2% to 25.8%. Since a capital return that reduced equity, and the sale of C10 Communications, ROE has been higher.

Cash flow is good (exceeds reported profits) and the balance sheet is debt free. Debt free, an attractive ROE and good cash flow are desirable characteristics, particularly when they appear in concert. Management have also shown they are owner-oriented, buying back shares last year at depressed prices equivalent to 10 per cent of today’s market cap, and plan to also provide a capital return through an unfranked dividend of 50c.

But this a small company, and I have done no work identifying whether any competitive advantages (the ability to regularly raise prices without a loss of sales volume) exist. They often don’t in small businesses. If they do, they tend not to be small for long. The focus is now on one business – Lemtronics. On first impressions, it is not the most memorable of brands.

My estimate of value is $4.00 – $4.50, but there are plenty of other companies whose businesses I know better.

By Roger Montgomery, 1 October 2009

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