This is from the Man's latest newsletter:
INTRINSIC
VALUE
Now
let’s focus on a term that I mentioned earlier and that you will
encounter in future annual reports.
Intrinsic
value is an all-important concept that offers the only logical
approach to evaluating the relative attractiveness of investments and
businesses. Intrinsic value can be defined simply: It is the
discounted value of the cash that can be taken out of a business
during its remaining life. The calculation of intrinsic value,
though, is not so simple. As our definition suggests, intrinsic value
is an estimate rather than a precise figure, and it is additionally
an estimate that must be changed if interest rates move or forecasts
of future cash flows are revised. Two people looking at the same set
of facts, moreover—and this would apply even to Charlie and me—will
almost inevitably come up with at least slightly different intrinsic
value figures. That is one reason we never give you our estimates of
intrinsic value.
What
our annual reports do supply, though, are the facts that we ourselves
use to calculate this value. Meanwhile, we regularly report our
per-share book value, an easily calculable number, though one of
limited use. The limitations do not arise from our holdings of
marketable securities, which are carried on our books at their
current prices. Rather the inadequacies of book value have to do with
the companies we control, whose values as stated on our books may be
far different from their intrinsic values.
The
disparity can go in either direction. For example, in 1964 we could
state with certitude that Berkshire’s per-share book value was
$19.46. However, that figure considerably overstated the company’s
intrinsic value, since all of the company’s resources were tied up
in a sub-profitable textile business. Our textile assets had neither
going-concern nor liquidation values equal to their carrying values.
Today, however, Berkshire’s situation is reversed: Now, our book
value far understates Berkshire’s intrinsic value, a point true
because many of the businesses we control are worth much more than
their carrying value.
Inadequate
though they are in telling the story, we give you Berkshire’s
book-value figures because they today serve as a rough, albeit
significantly understated, tracking measure for Berkshire’s
intrinsic value. In other words, the percentage change in book value
in any given year is likely to be reasonably close to that year’s
change in intrinsic value.
You
can gain some insight into the differences between book value and
intrinsic value by looking at one form of investment, a college
education. Think of the education’s cost as its “book value.”
If this cost is to be accurate, it should include the earnings that
were foregone by the student because he chose college rather than a
job.
For
this exercise, we will ignore the important non-economic benefits of
an education and focus strictly on its economic value. First, we must
estimate the earnings that the graduate will receive over his
lifetime and subtract from that figure an estimate of what he would
have earned had he lacked his education. That gives us an excess
earnings figure, which must then be discounted, at an appropriate
interest rate, back to graduation day. The dollar result equals the
intrinsic economic value of the education. Some graduates will find
that the book value of their education exceeds its intrinsic value,
which means that whoever paid for the education didn’t get his
money’s worth. In other cases, the intrinsic value of an education
will far exceed its book value, a result that proves capital was
wisely deployed. In all cases, what is clear is that book value is
meaningless as an indicator of intrinsic value.