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Buffet's definition of INTRINSIC VALUE from shareholders letter
Posted by: itznuthin1 (IP Logged)
Date: February 17, 2008 10:48PM
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.
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