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(MIKE SEGAR/Mike Seagar/Reuters)
(MIKE SEGAR/Mike Seagar/Reuters)

MoneyShow.com

Buffett's move makes perfect sense Add to ...

A lot of CEOs try to use news of a share buyback program to boost their stock price. And I’ll warn you that most CEOs are terrible investors. They initiate buybacks at the worst possible time, and therefore lose value for their shareholders.

But when Warren Buffett—undoubtedly the world’s best investor ever, and most honest executive—tells you he wants to buy back boatloads of his company’s stock, it should catch your attention.

About a month ago, Buffett offered to buy back an unlimited number of shares of Berkshire Hathaway or in an open-ended share repurchase program. The plan allows Buffett to buy back lots of stock at a price not to exceed a 10 per cent premium to book value.

Buffett’s buyback isn’t designed to boost Berkshire shares. The plan is in place because he believes that buying back Berkshire Hathaway stock at the right price is the best use of the company’s money to generate returns for current shareholders.

In fact, this is what the company’s press release said:

"Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10 per cent premium over the then-current book value of the shares.

In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest."

This announcement tells me that Buffett believes Berkshire shares are considerably undervalued, and that the buyback program is a better investment than many of the other opportunities available to the company.

So what is the current book value of Berkshire shares? As of Berkshire’s second-quarter filing with the SEC, the company’s book value was $98,716 per Class A share or $68.81 per B share.

Since then, the company has earned over three months of profits, boosting its book value. Hedge-fund manager Whitney Tilson estimates that Buffett is saying he’ll buy shares at up to roughly $108,588 per A share or $72.39 per B share, after accounting for growth in book value.

For existing Berkshire Hathaway shareholders, the plan essentially puts in a "floor" for the company’s stock at these prices, which are right below where the stock was trading on October 6, when Buffett made the announcement.

In addition to telling investors that Buffett thinks his stock is a steal at current levels, this announcement tells us one more thing: Buffett doesn’t foresee a devastating double-dip recession.

If he thought the global economy was on the verge of collapse, he wouldn’t be aggressively making new investments today, since lower prices would prevail in the future. This should be welcome news to investors who are "long" stocks, including Berkshire.

Full disclosure: I personally own shares of Berkshire B shares. Since the share repurchase plan was announced, I’ve been adding to my position in the stock.

Why would Buffett want to repurchase stock? Today, Berkshire is sitting on piles of cash. At the end of the second quarter, cash and short-term bonds totaled $77-billion (U.S.). The total value of the cash equals one-third of the company’s current market capitalization.

In the press release, Berkshire says that the company plans to always hold $20-billion in cash. As a result, we can assume that Berkshire has $57-billion in cash that the company is seeking to invest today.

In addition to its huge war chest of cash, Berkshire has amazing cash flow from its operations. In the first six months of this year, cash from operations was $6.5-billion. This means that every month more than $1-billion in free cash flow is pouring into the company’s coffers!

Simply put, Berkshire is a cash-generating machine that’s got money to invest on behalf of shareholders. And the company must make big investments in order to have a meaningful financial impact on its financial performance.

Right now, it looks like Buffett thinks a big investment in Berkshire Hathaway shares may be the most attractive opportunity.

Valuing Berkshire shares today Investors know what Berkshire shares are valued at today by the stock market. And they know that the world’s greatest investor wants to buy billions of dollars of the stock at slightly below the recent price.

But what is the true value of Berkshire Hathaway shares?

Like most investments, the answer is a bit complicated. But I’ll try to explain in simple terms why the stock could rise 50 per cent in the not so distant future.

Berkshire is an incredibly interesting business to value. It owns publicly traded investments including stocks and bonds such as Coca-Cola , Wells Fargo , American Express , Kraft , and Wal-Mart .

But the company also has outright ownership of countless businesses such as Geico, See’s Candies, NetJets, Fruit of the Loom, Dairy Queen, and Benjamin Moore Paints.

To value the company, investors must consider both the company’s investments and the privately held operating businesses.

The investments are easy to value, since they are publicly traded and their current value is known. At the end of the second quarter, these were valued at $95,500 per A class share.

Now the value of the company’s wholly owned operating businesses are a bit more difficult to value, since they aren’t publicly traded. The easiest way to peg a value on these operating businesses is to look at the earnings from these companies.

The annual pre-tax EPS of Berkshire (excluding income from the "investments") was $7,200. Assuming that the value of the operating businesses was ten times pre-tax EPS, these pieces of Berkshire would be worth an additional $72,000 per share.

The combined value of Berkshire’s investments ($95,500) and operating businesses ($72,000) would be $167,500 per A share at the end of the second quarter. After what is believed to be a solid third quarter, the intrinsic value is likely closer to $170,000 per A share or $113 per B share.

Compared to the recent share price, this implies that Berkshire shares would need to rise significantly in order to reach their intrinsic value today. Historically, Berkshire shares have bounced around, often trading above or below intrinsic value. However, they have always reverted back to intrinsic value over time.

Today, Berkshire Hathaway shares are trading at around 67 cents on the dollar. Meaning that patient investors are likely to see the share price rise to the intrinsic value at some time in the future.

With the potential for a 50 per cent gain once shares return to their intrinsic value, Berkshire shares look like a real bargain.

Ian Wyatt is a columnist with InvestorsInsight.com.

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