Berkshire Hathaway 2000 Annual Report Download - page 65

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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.