STREET DOGS

The calculation of intrinsic value is not so simple. ”– Anon.

From The Essays of Warren Buffett: Lessons for Corporate America, an explanation of the difference between book value and intrinsic value.

“Value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get. 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. Intrinsic value is an estimate rather than a precise figure.

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 noneconomic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings 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.”