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.
In one interview he has said:
"Intrinsic value is the number, that if you are all knowing about the future, and can predict all the cash that a business can give you between now and judgement day, discount it at a proper discount rate, that number is what the intrinsic value of a business is".
In one of Berkshire Hathaway annual reports, the calculation of the intrinsic value was given as:
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.
