What is the historical relationship between Berkshire’s share price and its book value?
The blue line in the chart below shows the % change in BRK-A shares during a fiscal year, and the red bars show the premium of share price over book value per share multiple (P/B) at the end of that fiscal year. The time period for the chart stretches the entire history of Berkshire of BRK-A’s trading since 1965 when Buffett took control of the company until 2014.
But since markets are forward-looking, a better way to look at this relationship between valuation and share price performance is to compare the P/B multiple at the end of the previous fiscal year and the % change in share price during the following fiscal year. In other words, the P/B at the end of 1995 was 2.23x which was followed up the next year by a 6.2% yearly increase in share price during 1996.
This would be similar to saying Company ABC was trading at a P/E multiple of 15.0x at the end of 2014. Said another way, Company ABC’s price per share/earnings per share was 15.0x or perhaps $150 current share price divided by $10.00 per share earned in the previous 12 months. It’s a trailing multiple, meaning these earnings per share were earned over the previous 12 months. In reality, Company ABC’s real-time stock price would trade on the market’s collective view on what Company ABC’s earnings will be for the next 12 months, as investors pay today for cash flows earned tomorrow/in the future, i.e. on a forward multiple of say 10.0x, or $150 current price per share divided by $15.00 in expected earnings per share for the next 12 months. This implies the markets are currently expecting Company ABC’s earnings per share (EPS) to increase 50% to $15 per share from the previous trailing 12-month EPS of $10.00.
When using book value, as is custom for investors in insurance companies, one normally doesn’t see forward P/B multiples. Why? Because the question for investors in insurance companies is slightly rephrased to, “What am I willing to pay now for every existing $1 on the balance sheet that currently belongs to me today?” Inherent in this question is an expectation of what this $1 on the balance sheet that belongs to me (i.e. $1.00 of book value per share, $1.00 net asset value per share, $1.00 of shareholders’ equity per on the balance sheet per share) will earn in the future. For instance, if the book value per share of a company is $1.00, and the market trading price per share for that company is also $1.00, this would mean that the market is expecting the company to neither create nor destroy shareholder value. Its P/B multiple is $1.00/$1.00 = 1.0x. But if it’s trading at 1.2x, this would mean that investors are willing to pay $1.20 for every $1.00 currently belonging to them on the balance sheet today because they expect this current $1.00 to be utilized by the insurance company to create more shareholder value. And if $1.20 paid for every $1.00 (1.2x) is the fair value, this would imply that the net present value of all future earnings (or “interest” paid to investors) by the insurance company on top of current book per share value of $1.00 (or “principal” to be paid back) equals 1.2 times every $1 already on the balance sheet. So in some ways it’s like valuing a bond. If the appropriate yield to maturity, which discounts future coupons and repayment of principal, values the bond at 110% or 110 of par value of 100, then the fair value of the bond is 1.10x of par.
For Berkshire, if we look at the P/B at the end of each year and its relationship to annual % change in share price over the following year, we would see there is an inverse correlation. Only one year when beginning of the year P/B was below 1.7x-1.8x did Berkshire’s share price decline more than 5% during the following year. This sole occurrence would be when P/B at the end of 1973 was 1.06x, which was followed up by a 48.7% annual decline in share price during 1974. But this was likely an overreaction by the markets. As a fund manager owning a position in BRK-A at this time, you probably would have faced investor redemptions. But, if your investors were patient enough with you and understood markets were equally capable of overreacting on the downside as they are on the upside, your investors would have been fortunate to have earned annual share price gains of more than 100% twice during the following 5 years, with average annual share price increases in BRK-A of 73.2%.