“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses,” Warren Buffett said in the 2016 Annual Report of Berkshire Hathaway.
“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,” said the Berkshire Hathaway chairman. “The calculation of intrinsic value, though, is not so simple.”
Berkshire Hathaway’s definition suggests that 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 (Munger) 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.”
Warren Buffett said that Berkshire’s book-value figures today served 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,” he said.
Mr Buffett then used college education as one form of investment to help one gain some insight into the differences between book value and intrinsic value .
“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.”