Berkshire Hathaway 2014 Annual Report Download - page 123

INTRINSIC VALUE
Now let’s focus on a term that I mentioned earlier and that you will encounter in future annual reports.
Intrinsic value is 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.
THE MANAGING OF BERKSHIRE
I think it’s appropriate that I conclude with a discussion of Berkshire’s management, today and in the future. As our first owner-
related principle tells you, Charlie and I are the managing partners of Berkshire. But we subcontract all of the heavy lifting in this
business to the managers of our subsidiaries. In fact, we delegate almost to the point of abdication: Though Berkshire has about
340,000 employees, only 25 of these are at headquarters.
Charlie and I mainly attend to capital allocation and the care and feeding of our key managers. Most of these managers are
happiest when they are left alone to run their businesses, and that is customarily just how we leave them. That puts them in charge of
all operating decisions and of dispatching the excess cash they generate to headquarters. By sending it to us, they don’t get diverted by
the various enticements that would come their way were they responsible for deploying the cash their businesses throw off.
Furthermore, Charlie and I are exposed to a much wider range of possibilities for investing these funds than any of our managers
could find in his or her own industry.
Most of our managers are independently wealthy, and it’s therefore up to us to create a climate that encourages them to choose
working with Berkshire over golfing or fishing. This leaves us needing to treat them fairly and in the manner that we would wish to be
treated if our positions were reversed.
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