Berkshire Hathaway 1999 Annual Report Download - page 61

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AN ADDED PRINCIPLE
To the extent possible, we would like each Berkshire shareholder to record a gain or loss in market value
during his period of ownership that is proportional to the gain or loss in per-share intrinsic value recorded
by the company during that holding period. For this to come about, the relationship between the intrinsic value
and the market price of a Berkshire share would need to remain constant, and by our preferences at 1-to-1.
As that implies, we would rather see Berkshire's stock price at a fair level than a high level. Obviously,
Charlie and I can't control Berkshire's price. But by our policies and communications, we can encourage
informed, rational behavior by owners that, in turn, will tend to produce a stock price that is also rational.
Our it's-as-bad-to-be-overvalued-as-to-be-undervalued approach may disappoint some shareholders. We
believe, however, that it affords Berkshire the best prospect of attracting long-term investors who seek to profit
from the progress of the company rather than from the investment mistakes of their partners.
INTRINSIC VALUE
Now let's focus on two terms that I mentioned earlier and that you will encounter in future annual reports.
Let's start with intrinsic value, an all-important concept that offers the only logical approach to evaluating the
relative attractiveness of investments and businesses. 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.
The calculation of intrinsic value, though, is not so simple. As our definition suggests, 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 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.
Meanwhile, we regularly report our per-share book value, an easily calculable number, though one of limited
use. The limitations do not arise from our holdings of marketable securities, which are carried on our books at their
current prices. Rather the inadequacies of book value have to do with the companies we control, whose values as stated
on our books may be far different from their intrinsic values.
The disparity can go in either direction. 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 company'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. Today, however, Berkshire's situation is reversed: Now, our book
value far understates Berkshire's intrinsic value, a point true because many of the businesses we control are worth much
more than their carrying value.
Inadequate though they are in telling the story, we give you Berkshire's book-value figures because they today
serve 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.
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 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.