Is There A Reason Why Berkshire Hathaway Is Buying Back Its Stock?

Billionaire investor and owner of Berkshire Hathaway recently dropped a bomb earlier this month.

Breaking with typical Berkshire Hathaway tradition, and changing the rules that Warren Buffett has laid down for himself financially, Berkshire Hathaway is actually buying back some of its own stock – and plans to continue buying back more stock as long as it doesn’t go over the price of 1.2 times book value.

What is book value anyway?

Before a company is assembled into a whole corporate stock, book value is the price of its separate constituent parts. A technical definition of book value is defined like this: “the net asset value of a company, calculated by total assets minus intangible assets (patents, goodwill) and liabilities.”

But don’t let that definition throw you for a loop. You do not need to understand the specific financial aspects of this transaction in order to truly understand what this story represents.

Here’s the most important thing that you need to grasp: not much longer than a year ago, in this past September of 2011, Warren Buffett announced that Berkshire Hathaway is going to buy back its shares at 110% of the book value of the company. This was a surprising move on Buffett’s part because for many years in the past Warren Buffett has been very critical of buying back shares of any company – and how many companies use this as a way to pump up the price of their shares.

Nonetheless, this past September Warren Buffett told the world that he’s going to start buying back shares as well. He also said that he would keep on buying back shares as long as the price was at the level that he was willing to pay, or potentially lower. This could possibly have him buying back billions of dollars worth of Berkshire Hathaway shares, because in Warren Buffett’s opinion the business is “worth considerably more” then the Berkshire Hathaway shares are currently selling.

Now fast-forward to December 2012. Earlier in the month, Mister Buffett also announced that he’s going to take it a step further by paying up to 120% of the company’s book value, which comes out to 1.2 times.

So what exactly does this buyback mean?

You could look at Warren Buffett’s announcement recently in two different ways. If you look at it the first way, according to the way that Mister Buffett would probably spend it, is that Berkshire Hathaway is buying back their shares because they find them at an incredible value according to the current price as of today. And there is definitely much truth to that statement.

If you look back throughout Berkshire Hathaway’s history, you will see that it traditionally sold a lot higher than 1.1 times of the company’s book value, or even 1.2 times for that matter. As a matter of fact, over the last 12 years of the 21st century, the average price of Berkshire Hathaway shares sold at least 1.5 times their book value. And there were even times where the stock occasionally sold for more than double its book value.

So, if you look at Berkshire Hathaway’s shares on the surface, you can see that buying at 1.2 times book value is definitely paying a discount for the shares when you compare it to the usual price. This is about 20% below the average cost.

What else could this move mean to Warren Buffett?

Another way that you might possibly explain this move by Warren Buffett and his decision to purchase more of Berkshire Hathaway stock is by saying this: doing so is actually the lesser of evils.

As I’m sure many of you know, one of the biggest problems Berkshire Hathaway faced over recent years is that it doesn’t know what to do with all of its money. At the time of this writing, Berkshire is currently sitting on $47.8 billion in cash as of now. Since banks are only paying 0.1% interest, he actually can’t afford to just sit on the money. He has to actually invest it into something.

Throughout other portions of the market, we are seeing a plethora of mergers and acquisitions as many other companies throw around bags of cash, by investing their cash in company buyouts.

Over the last few weeks alone, we have seen TJX buy Sierra Trading Post for $200 million. We also saw Oracle buy Eloqua for the amount of $850 million. Avio Aviation was sold to General Electric for a very large $4.3 billion. Since Buffett and company have around $48 billion to invest, they could have chose to make any of these deals without even thinking twice about it.

But they didn’t.

Instead, since Warren Buffett is the smartest investor in the world today, and possibly even the smartest businessman throughout the history of the world – what did he do? He looked around at various investment opportunities on the stock market, noticed that many of the companies there were selling for two times book value, and then muttered to himself “too expensive, too expensive.” Then he must’ve looked at his own stock for a second time and realized that even though it isn’t as cheap as it was in the past, it’s actually a lot cheaper than many of the other companies on the market today.

This is why Buffett decided to up his spending limit and agreed to buy his own stock for 1.2 times book value, instead of paying about twice that for other companies that were not as good.

Is there any meaning to this move for other stock market investors?

It’s safe to say that you shouldn’t accuse Warren Buffett of dumb luck on his road to becoming a billionaire. And he obviously doesn’t make any stupid decisions by paying more for a business that it’s actually worth.

Here’s a really important question that you need to ask yourself as an investor: since Warren Buffett took a look at the stock market and couldn’t find anything to purchase that’s cheaper than his own company Berkshire Hathaway, and he actually is willing to pay more for his own stock that he was originally willing to pay, what does this mean for you as an investor?

To put it bluntly, it means you should seriously think twice about spending your money on companies in an overpriced stock market as well.

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