Intrinsic Value

The Intrinsic Value of a company is the Adjusted Net Asset Value of a company, based on Fundamental Analysis. The measurement of Intrinsic Value can be derived from both operating businesses as well as from the value of non-operating assets, taking both tangible and intangible factors into account.

Book Value and Intrinsic Value

In his letter to Berkshire Hathaway shareholders in 1995, Warren Buffett explains how he and Charles Munger view Intrinsic Value and how it differs from the stated Book Value of a company.

We regularly report our per-share book value, an easily calculable number, though one of limited use.  Just as regularly, we tell you that what counts is intrinsic value, a number that is impossible to pinpoint but essential to estimate.

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 stock’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. In 1964, then, anyone inquiring into the soundness of Berkshire’s balance sheet might well have deserved the answer once offered up by a Hollywood mogul of dubious reputation: “Don’t worry, the liabilities are solid.”

Today, Berkshire’s situation has reversed: Many of the businesses we control are worth far more than their carrying value (Those we don’t control, such as Coca-Cola or Gillette, are carried at current market values). We continue to give you book value figures, however, because they serve as a rough, albeit significantly understated, tracking measure for Berkshire’s intrinsic value.  Last year, in fact, the two measures moved in concert:  Book value gained 13.9%, and that was the approximate gain in intrinsic value also.

We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.

To see how historical input (book value) and future output (intrinsic value) can diverge, let’s look at another form of investment, a college education. Think of the education’s cost as its “book value.”  If it is to be accurate, the cost 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.

Intrinsic Value and Capital Allocation

In the same letter, Buffett goes on to explain how the intrinsic value of a company is affected by the capital allocation decisions of its management:

Understanding intrinsic value is as important for managers as it is for investors.  When managers are making capital allocation decisions – including decisions to repurchase shares – it’s vital that they act in ways that increase per-share intrinsic value and avoid moves that decrease it.  This principle may seem obvious but we constantly see it violated. And, when misallocations occur, shareholders are hurt.

For example, in contemplating business mergers and acquisitions, many managers tend to focus on whether the transaction is immediately dilutive or anti-dilutive to earnings per share (or, at financial institutions, to per-share book value).  An emphasis of this sort carries great dangers. Going back to our college-education example, imagine that a 25-year-old first-year MBA student is considering merging his future economic interests with those of a 25-year-old day laborer.  The MBA student, a non-earner, would find that a “share-for-share” merger of his equity interest in himself with that of the day laborer would enhance his near-term earnings (in a big way!).  But what could be sillier for the student than a deal of this kind?

In corporate transactions, it’s equally silly for the would-be purchaser to focus on current earnings when the prospective acquiree has either different prospects, different amounts of non-operating assets, or a different capital structure. At Berkshire, we have rejected many merger and purchase opportunities that would have boosted current and near-term earnings but that would have reduced per-share intrinsic value. Our approach, rather, has been to follow Wayne Gretzky’s advice: “Go to where the puck is going to be, not to where it is.”  As a result, our shareholders are now many billions of dollars richer than they would have been if we had used the standard catechism.

The sad fact is that most major acquisitions display an egregious imbalance:  They are a bonanza for the shareholders of the acquiree; they increase the income and status of the
acquirer’s management; and they are a honeypot for the investment bankers and other professionals on both sides.  But, alas, they usually reduce the wealth of the acquirer’s shareholders, often to a substantial extent. That happens because the acquirer typically gives up more intrinsic value than it receives.  Do that enough, says John Medlin, the retired head of Wachovia Corp., and “you are running a chain letter in reverse.”

Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value. Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally.  The company could, of course, distribute the money to shareholders by way of dividends or share repurchases. But often the CEO asks a strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense. That’s like asking your interior decorator whether you need a $50,000 rug.

The acquisition problem is often compounded by a biological bias: Many CEO’s attain their positions in part because they possess an abundance of animal spirits and ego. If an executive is heavily endowed with these qualities – which, it should be acknowledged, sometimes have their advantages – they won’t disappear when he reaches the top.  When such a CEO is encouraged by his advisors to make deals, he responds much as would a teenage boy who is encouraged by his father to have a normal sex life. It’s not a push he needs.

Some years back, a CEO friend of mine – in jest, it must be aid – unintentionally described the pathology of many big deals. This friend, who ran a property-casualty insurer, was explaining to his directors why he wanted to acquire a certain life insurance company.  After droning rather unpersuasively through the economics and strategic rationale for the acquisition, he abruptly abandoned the script.  With an impish look, he simply said: “Aw, fellas, all the other kids have one.”

The Primacy of the Income Account

The late Marty Whitman, in his book Modern Security Analysis, but great emphasis on the fact that in modern finance theory the importance of generating earnings is in many cases overemphasized. In numerous cases, great wealth has been created for shareholders, without the realization of significant accountable earnings. One such case would be the case of John Malone at TCI and Liberty.

How Corporate Value is Created

In Whitman’s mind, there are more ways a company creates value. To be exact, there are three other ways a company creates value for its shareholders. In a letter to shareholders in the 2011 Third Avenue Funds Annual Report, he explains:

In [Fundamental Finance], stockholder values flow out of creating corporate values. There are four different ways corporate values are created:

  1. Cash flows available to security holders. This is probably created by corporations fewer times than most people think.
  2. Earnings, with earnings defined as creating wealth while consuming cash. This is what most well-run corporations do and also most governments do. Earnings cannot have a lasting value unless the entity remains creditworthy. Also, in most cases, in order to maintain and grow earnings, the corporation or government is going to have to have access to capital markets to meet cash shortfalls.
  3. Resource Conversion. These areas include massive asset redeployments, massive liability redeployments and changes in control. Resource conversion occurs as part of mergers and acquisitions, contests for control, the bulk sale or purchase of assets or businesses, Chapter 11 reorganizations, out of court reorganizations, spin-offs, and going privates including leveraged buyouts (“LBOs”) and management buyouts (“MBOs”).
  4. Super attractive access to capital markets. On the equity side, this includes initial public offerings (“IPOs”) during periods such as the dotcom bubble.
    On the credit side, this includes the availability of long-term, fixed rate, and non-recourse financing for income producing commercial real estate.

G&D do not distinguish between cash return investing and total return investing. In cash return investing, returns are measured by current yield (or dividend return), yield to maturity, yield to worst or yield to an event. In total return investing, returns are measured in the price paid relative to cash returns plus (or minus) capital appreciation (or depreciation) in given periods of time. Many portfolios have to be invested only for cash return into high-grade credits, e.g., bank securities portfolios; insurance company portfolios, at least as to the amount of liabilities; certain pension plans. (In the current low-interest environment, it seems almost impossible to be a rational cash return investor.) For G&D, the higher the dividend, the higher the price at which a common stock would sell. G&D imply that the higher dividend issue should be acquired. G&D ignore that the lower priced security may be more attractive to the total return investor because of the lower price and the larger amount of retained earnings.

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