From Warren Buffett’s 1994 letter to Berkshire Hathaway shareholders:
Don’t worry, the liabilities are solid. – Hollywood mogul on the soundness of a balance sheet.
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, 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 invest-ment, 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 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 the graduate will receive over his lifetime and subtract an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must 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 their 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.