BOOK VALUE AND INTRINSIC BUSINESS VALUE |Q&A WITH WARREN BUFFETT ON BOOK VALUE, COST OF CAPITAL, INTRINSIC VALUE

Book Value And Intrinsic Business Value

Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously – from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value.” Berkshire 1983 Letter

1. What do you think of the use of book values in making investment decisions? Source: BRK Annual Meeting 1995

Book value is virtually not a consideration in investment Decision making at Berkshire. Their pursuit of high return businesses usually leads to companies with minimal book values.

Munger proffered that “projections generally do more harm than good, and are usually prepared by persons who have some sort of an interest in the outcome of actions based on the projections. They often have a precision that’s deceptive. ” Buffett added that they’ve never looked at a projection in connection with an equity or business that they’ve acquired. “It’s a ritual to justify doing what an executive or a board wanted to do in the first place.

2. What is the intrinsic value of Berkshire? Can you use book value as a guide to company valuations? Source: BRK Annual Meeting 2000

Really wonderful businesses need no book value. Book value is not a great proxy for intrinsic value and it is not a substitute. Berkshire was not worth book value in 1965, intrinsic value was below book value, now the business is worth a great deal more than book value. Book value is not a bad starting point for Berkshire when trying to calculate intrinsic value. We generally do not look at book value when evaluating a stock.

Re: How would Warren value Berkshire?: I’d think about what’s there, what are they trying to do, what’s it worth if they don’t succeed in deploying additional capital, and what it’s worth if they do. What are the resources available to keep adding to the collection of businesses? I think you’ll find the information [in the annual report] that you need to evaluate Berkshire. Don’t take it out to 4 decimal places. If Charlie and I had to write down a number, it would be different but in the same ballpark. What Berkshire will be worth 10 years from now will depend on earnings, the quality of those earnings and the liquid assets we have. We keep working on it, but we’re so big.

There’s no way in the world we can replicate the past, but hopefully we do a reasonable job. Everything is affected by everything else in the financial world.

3. What is Berkshire’s cost of capital? Source: BRK Annual Meeting 2003 Tilson Notes

Charlie and I don’t know our cost of capital. It’s taught a business schools, but we’re skeptical. We just look to do the most intelligent thing we can with the capital that we have. We measure everything against our alternatives. I’ve never seen a cost of capital calculation that made sense to me. Have you Charlie? [CM: Never. If you take the best text in economics by Mankiw, he says intelligent people make decisions based on opportunity costs in other words, it’s your alternatives that matter. That’s how we make all of our decisions. The rest of the world has gone off on some kick there’s even a cost of equity capital. A perfectly amazing mental malfunction.]

4. What economic laws have worked best for Berkshire? (BRK Meeting 1995)

It is all a matter of trying to find businesses with wide moats protecting a large castle occupied by an honest lord. Moats might be a natural franchise, brand loyalty, or being a low cost producer. In a capitalistic society, all moats are subject to attack: if you have a good castle, others will want it. What we want to figure out is what keeps the castle standing and how smart is the lord.

[CM: we also like to look for low agency costs on that lord, economies of scale and “economies of intelligence.”] Buffett elaborated on the “economies of intelligence”: the idea is to find businesses where you have to be smart only once instead of being smart forever. Retailing is a business where you have to be smart forever: your competitors will always copy your innovations. Buying a network TV station in the early days of television required you to be smart only once. In that kind of business, a terrible manager can still make a fortune. Given the choice between the two (a business where you have to be smart forever or one where you have to be smart once), Buffett advised, pick the great business be smart once.

 

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