RedHawk Fund

Equity Research Report

Berkshire Hathaway Inc. –

B share

Date: 12/20/2014

Authors: Yichen Fan

Ticker: NYSE:BRK-B Recommendation: ●BUY

Berkshire Hathaway

Financial

Current Price: ● $151.54 Price Target: ●$170

INVESTMENT THESIS

o Low cost of large size float: Berkshire Hathaway Inc.’s insurance subsidiaries have a track record of high quality underwriting, having generated underwriting gains for last three years. The good insurance performance provided zero or even negative cost of capital to Berkshire Hathaway Inc.’s portfolio. Moreover, this float is growing at an incredible rate. This is an important distinction between Berkshire and other investment funds, which are dependent on the public market.

o Stable and remarkable investment: Berkshire Hathaway Inc. consistently beat the market for several years. With the best capital allocation in the world, it earns above average and consistent profit. It is less risky because it engaged in diversified business. Compared with other funds, Berkshire has better access to non-traditional investment opportunities. For example, it can buy another business as a subsidiary. Because of the good reputation, many investment ideas flow to Berkshire first before anyone could get it.

o Safety: Rock solid financial strength and famous reputation gives Berkshire Hathaway Inc. unmatchable competitive advantage in insurance industry. It is not subject to liquidity risk no matter what happened in equity market. Furthermore, Berkshire and its subsidiaries are engaged in diversified businesses, which reduce the unsystematic risk for the stock.

• 5-Year Stock Price Trend –

From the given 5-year stock price chart, BRK-B shares have outperformed the S&P 500 by around 50%.

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Redhawk Fund

Berkshire Hathaway

Financial

Market Profile

Market Cap. 248.86M ROA 4.13%

52 Week Range 44.82 ROE 9.30%

Dividend/Yield N/A ROI 7.86%

P/E Ratio 17.2 Profit Margin 10.69%

Forward P/E Ratio N/A Quick Ratio N/A

Beta 0.29 Current Ratio N/A

BUSINESS OVERVIEWBerkshire Hathaway Inc. is a publicly owned holding company. It was founded in 1889 and is based in Omaha, Nebraska as

a textile company. The chairman, main shareholder and CEO of the company, Warren Buffett, bought the company at 1962 and expand it to insurance industry and other investment. Berkshire Hathaway Inc. owning subsidiaries engaged in diversified investments, property & casualty insurance and railway.

• Berkshire Hathaway Inc.’s insurance and reinsurance business activities are conducted through GEICO, General Re,

Berkshire Hathaway Reinsurance Group and Berkshire Hathaway Primary Group. These businesses generate large amounts of float, which can be invested in high quality bonds or treasuries. These insurance companies provide low cost float to investment, as it is essentially free. The insurance and other financial services cover 65% of Berkshire Hathaway Inc.’s Asset.

• Through its subsidiaries, Berkshire Hathaway Inc. provides financial services and financial products. These businesses

represent 5% of Berkshires’ Asset.

• The company holds 47 stocks included Wells Fargo & Co., Bank of New York Mellon Corp., Chicago Bridge& Iron

Company N.V. etc. among 12 sectors and mainly weighted in Financials (43.8%) Consumer Staples (24.74%) and Information Technology (13.07%). The value of the whole portfolio over 110 billion.(CNBC)

• By its subsidiaries, Berkshire Hathaway Inc. also engaged many other industries, which includes railroad, utilities and

energy. Mr. Buffett provides the oversight to each subsidiary CEO and CEOs are responsible for their specialized businesses. However, Mr. Buffett will take charge of the free cash flow generated by each subsidiary and reallocates capital to subsidiaries or investments. These businesses covered 30% of Berkshire Hathaway’s Inc.

Financial Performance

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Redhawk Fund

Berkshire Hathaway

Financial

• Liquidity: Berkshire Hathaway Inc.’s balance sheet reflects significant liquidity. It owns a s strong reserve and huge

amount of trading securities. Berkshire Hathaway Inc. can use the money to pay its policy holder’s claim.

• Book Value per Share: Berkshire Hathaway Inc.’s Book value has grown around 10% over the last 10 years. During 2011-2012, it grew at two digit rates. Because the company repurchases its shares when the P/B ratio is below 1.2, the book value can set a floor for the share price.

2014 E

2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Average

Book Value Per Share

105 94.93 80.32 70.21 67.1 59.33 49.37 54.61 49.2 41.58 39.1

Growth rate 11%(E) 18% 14% 5% 13% 20% -10% 11% 18% 6% 11%

•

Industry Overview and Competitive Positioning

• Macroeconomic Factors and industry overview:

o We expect that the U.S. economy will grow faster in 2015: After slowing down in the last quarter of 2014,

we forecast the GDP will perform strongly in the following quarters because of the continued job growth pulls the consumption.

o We are cautiously optimistic for insurance industry for next year: Insurance industry is a business with

little scope of differentiation. The demand side is relatively stable and the supply side depends on capital. It has earned year-over-year earnings gain because fewer claims were paid in 2014, but it also pressures the rate for next year. We believe that most insurance companies can get a reserve-to-loss ratio of three to one, which can cover an about-normal level of catastrophes. Because of past events, we observed the insurers have tightened standards and enforce it. Therefore, though the industry is really depending on the weather, we are optimistic for the industry next year.

o The oil price drop has hurt the Berkshire Hathaway Inc.’s interest: The huge drop in oil price from

$110/barrel to less than $70/barrel did significantly damage in energy sector. It lost 12% on the total return basis during 2015. Berkshire Hathaway owns roughly $5.1 billion shares in five energy stocks (XOM, COP, NOV, PSX, SU). In addition, two of Berkshire Hathaway Inc.’s subsidiaries, Burlington Northern Santa Fe

railroad and Berkshire Hathaway Energy, even have more exposure to oil prices.

RISK ASSESSMENT• Key people: Berkshire Hathaway Inc.’s Major investment decisions and all major capital allocation decisions are made

by Warren E. Buffett, Chairman of the Board of Directors and CEO, age 83. In the past several decades, Mr. Buffett has proved extraordinary investment skills and accomplished unprecedented achievement. Concerning Mr. Buffett’s age, if his service is unavailable, it will be a great loss for Berkshire Hathaway Inc. It is obvious that there is nobody with such a reputation and experience as Mr. Buffet. After Mr. Buffett, it appears that Mr. Buffett’s position will be split into three positions after he retires. It is doubtful that if the inheritors could cooperate well and meet the market expectation to Warren Buffet. For now, Howard Graham Buffett, the second son of Mr. Buffett, is expected to be the

chairman and two of Mr. Buffett’s lieutenants, Todd Combs and Ted Weschler, may take important positions because

of their unexpected frequent involvement in the business recently. However, we also noticed that this risk remain for

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Berkshire Hathaway

Financial

Berkshire for the last ten years, it is reasonable to assume that the market has already prepared for his retirement. In this report, we didn’t give any credits to Mr. Buffett’s investment skills.

• Estimation of insurance expense: Insurance business is fundamentally hard to predict. Berkshire Hathaway Inc.’s

insurance business may suffer unexpected loss from natural catastrophes, terrorist, disease, or other unforeseen events. For the past five years, the float for Berkshire has grown at 5.8%, which is an incredibly high rate for an insurance company. Mitigating this risk, however, is Berkshire’s good reputation in its underwriting quality. We suspect Berkshire can generate underwriting gains in the future. In our report, we will use conservative number for the cost of float.

• Risk of extraordinary event to investment portfolio: Base on Berkshire Hathaway Inc.’s portfolio size, we believe

that the investments are too concentrated, and some stocks, such as Wells Fargo, Coca Cola, American Express and Walmart, are highly overweighed. We agree that these stocks are extremely valuable, stable and have “economic moat”. We also agree that this small number of stocks is incredibly diversified in different industries. However, we still suspect the risk of an extreme event to one of overweighed stocks may cause huge loss.

• Risk of regulation: The insurance companies have been hardly regulated. Regulations require every company to hold

statutory reserves. However, it is possible that regulators will start to restrict the investment types for float. Some countries, like China, require the stock investment cannot exceed the 20% of total capital. If the U.S. regulator conducts a more conservative regulation, Berkshire Hathaway Inc. may lose its competitive advantage.

VALUATION • Direction: Because of the complicated business structure, it is hard to simply use a basic valuation model and it will

be too detailed to value each subsidiary in its applicable different way. However, most of investors believe that Berkshire Hathaway Inc. has two main values which were endorsed by Mr. Buffett. One of them is its insurance operation, included the value of insurance operation, float and securities. The other one is its non-insurance operations, included its diversified non-insurance subsidiaries. Therefore, we would like to use a sum of parts approach valuing individual business segments using methods appropriate for each.

• Assumptions:

o Methodology selection: Berkshire Hathaway Inc. is largely engaged in financial services, which is hard to

use a traditional discounted cash flow model for because the reinvestment will be treated as expense in accounting. It also doesn’t pay dividends. Therefore we will use Float Based valuation to value the insurance business. Float-based valuation was pioneered by Alice Schroeder and Gregory Lapin in their well-known paper on Berkshire Hathaway published in 1999. Its values intrinsic value is a sum of the net tangible assets and the estimated value of float. We believe it is a good model here because the float is the main driver of Berkshire’s value. This would be the primary approach used to value insurance segment in this report. We will use P/E multiplier to value other businesses. Base on the diversified companies, we believe industry P/E ratio is comparable. Since float-based valuation is controversial and is sensitive to inputs, we will also present Price-Book multipliers valuation as a yardstick because P/B ratio is widely acceptable and accurate for financial services companies.

o Class B stocks: Berkshire Hathaway Inc. decided that the Class-B price per share will not exceed 1/1500

Class A price per share. From historical price, we observed that the Class-B stock share price concisely stay in the price ceiling. We believe that we can assume one share of Class B share price equal to 1/1500 of one share of class-A stock price.

• Valuation Model

o Float Based Valuation and P/E Multiplier Valuation:

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Berkshire Hathaway

Financial

▪ Insurance Subsidiaries(Float Based Valuation):

• Model: In Float Based Model, we will calculate the intrinsic value of Berkshire

Hathaway’s insurance business by adding the net present value of the forecasted cash flows emanating from the use of policyholder float to the statutory capital levels held in the insurance business.

• Float: The float in Berkshire has grown at 5.8% for past five years, which is a rapid rate

for insurance companies. We believe the float will keep growing at 3.5% in perpetuity, which is considered as the normal growth rate. If the rate is higher than 4%, we believe that will be a negative sign to the underwriting quality. Berkshire Hathaway Inc.’s insurance subsidiaries generate underwriting gain over past three years, so the cost of float is at a negative rate. However, considering the high growth rate for float, we believe it is more conservative to assume the cost of float is closer to zero.

• Return: We assume the return of float will not far exceed the 30 years treasury yield. The current 30 years treasury yield at 2.8%, but we believe it will rise to normalized levels soon. Therefore, we project 5% return on float base on the 30 years treasury yield before the recession. Note that this does not give any credit to Mr. Buffett’s investment skills because he could retire at any time.

• Discount rate: We give six percent discount rate because Berkshire is a triple A company and it can generate capital by float for free. It will be unrealistic to use beta to estimate the cost of capital for Berkshire.

• Statutory capital: $129 billion (2013 annual report, page 91)• We estimate the value of insurance operation is $299 billion

▪ Financial services(P/E):• Projected Earning: The pre-tax operating income for Berkshire Hathaway Inc.’s

financial services is $3,642 million for 2013. The growth rate is close to 13%. We estimate it will grow at the same rate which will result in approximately $4 billion of pre-tax income, which makes tge the after tax operating income from financial service operation is around 2,800 million.

• P/E ratio: According to Yahoo Finance, the average P/E ratio for non-banking financial service company is 11.26. We believe this P/E ratio is reasonable.

• We estimate the value of financial services operation for Berkshire Hathaway Inc. is $31,528 million.

▪ Other Business(P/E):• Projected Earning: Except insurance and financial services, Berkshire Hathaway Inc.

also engaged in many different businesses. Because of diversified businesses and the exposure in oil price, we assume it will not exceed the net income last year. We will use the P/E ratio of S&P 500. The before tax operating income from other businesses in 2013 is close to $7034.5 million. We estimate the after tax operating income from other businesses in 2014 will be close to $4,900 million, which is same as 2013. The P/E ratio for S/P 500 is 19.48

• We estimate the value of other business operation for Berkshire Hathaway Inc. is $95,452 million

▪ Intrinsic value per share: We estimate the total value of equity is $425 billion. By assume the price of Class-B stocks is 1/1500 of class A stocks, we estimate the intrinsic value for Class-B share is $177 per share.

o P/B Multiplier Valuation:

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Berkshire Hathaway

Financial

▪ Growth: During the past two years, the book value of Berkshire Hathaway grows around 16%. It is

mainly because the stock repurchase However, we expect the increase rate will drop to because the large size of capital base. We believe 11% will be a proper growth rate because it is the average BV growth rate for last 10 years.

▪ Multiplier: Since Berkshire’s main value is contributed by its insurance business, their asset is

highly liquidity. Therefore, we believe P/B ratio could provide a bottom line for the value of Berkshire. Because Berkshire Hathaway Inc. is highly diversified and the price of stock is influenced by many factors, we decide to use different P/B multipliers to value different businesses and sum them up. We decide to break Berkshire to insurance business, financial service business and other business. Moreover, because the new stock repurchases policy discussed above, we believe it is reasonable to estimate the P/B leading multiplier will be slightly higher than the average of P/B multipliers before recession.

▪ We estimate the value of to be $168/share.

RECOMMENDATIONS

We give a cautious buy recommendation to Berkshire Hathaway Inc. The company has its “economic moat” built from its competitive advantage. We estimate the Berkshire Hathaway Class-B shares intrinsic value as of year-end 2014 is in the range of $172 to $177. In our view, a substantial margin of safety exists for shareholders at prices below $170 per Class-B share. The main reason to buy this stock is because of the large and no cost float, remarkable investment return, and diversified business. We believe the stock price remains 10% upside potential. Buying the stock at $170 per share is a fair value for the outstanding business and obtains satisfactory return.

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Redhawk Fund

Berkshire Hathaway

Financial

EXHIBIT 1: INCOME STATEMENTin millions

SOURCE: COMPANY DOCUMENTS, STUDENT ESTIMATES

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Redhawk Fund

Berkshire Hathaway

Financial

EXHIBIT 2: BALANCE SHEETin millions

SOURCE: COMPANY DOCUMENTS, STUDENT ESTIMATES

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Redhawk Fund

Berkshire Hathaway

Financial

EXHIBIT 3: STATEMENT OF CASH FLOWSin millions

SOURCE: COMPANY DOCUMENTS, STUDENT ESTIMATES

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Redhawk Fund

Berkshire Hathaway

Financial

Exhibit 4 Float-Based Valuation Analysis

Insurance Subsidiary Valuation= Present value of float + Statutory capital

Present Value of float= next year Cash Flow/Capitalization Factor

(We will treat the present value calculation as a “growing perpetuity”)

Where: Next year Cash Flow= current float*(Investment Return-Cost of Float-Tax Burden)

And: Capitalization Factor= Discount Rate- Growth Rate

Value($ in million)

Float 2014(billion) 79310 (3% grow from last year Insurance 298917.7095

Return of Float 5% Anticipated 30 years treasury rate

Financial service 31500

Cost of Float 0 Other business 95500

Tax 1%  Estimate by Mr. Buffett Total value 425917.7095

One year cash flow 3172.4 Class A shares outstanding

1.6

Discount rate 6% Anticipated 30 years treasury rate

Class B shares outstanding

1.64

Growth rate 3.5% growing perpetuity Instinct value of Class-B shares

177.3445269

Capitalization Factor 2%

Present value of float 169917.7095

Statutory Capital 129000 2013 annual report

Insurance valuation 298917.7095

SOURCE: COMPANY DOCUMENTS, STUDENT ESTIMATES, MORNINGSTAR.COM

Yichen Fan 11 Seattle University

Redhawk Fund

Berkshire Hathaway

Financial

Exhibit 5 P/B Ratio Valuation Analysis

BRK.B Estimate Insurance Industry Avg. S&P 500 Financial Industry Avg.1.64 1.2 2.7 1

65% 30% 5%BRK.B Book value per share

BRK.B Estimate BV Multiplier

BRK.B instinct value per share

105 1.64 172.2

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Redhawk Fund