Berkshire Letter by Warren Buffett – 1994 (Part 2)
Mar 9th, 2007 by Martin Lee
Book Value and Intrinsic Value
Warren Buffett considers intrinsic value as the only logical way to evaluate the relative attractiveness of investments and businesses. It is defined as the discounted value of cash that can taken out of a business during its remaining life.
This value is highly subjective as it depends on estimations of future cash flows and changing interest rates.
An example of college education is used by Warren to illustrate the possible divergence from book value and intrinsic value.
First, let’s treat the cost of education as it’s “book value”.
Then, we must estimate the earnings that will be earned by the graduate over his lifetime and subtract what he would have earned if he didn’t have his college education.
This excess earnings should then be discounted back to graduation day using an appropriate interest rate. The final value represents the intrinsic value of the college education.
Some graduates may calculate that the book value of their education exceeds the intrinsic value, which meant they overpaid. Other graduates may calculate and find the converse, which meant that capital was wisely deployed.
No matter what, it is clear that book value does not figure as a calculation for intrinsic value.
Now, let’s look at a real life Berkshire example.
Scott Fetzer was bought by Berkshire at the beginning of 1986 for $315.2 million, which at the time of purchase had $172.6 million of book value. A premium of $142.6 million was paid as Warren Buffett believed the intrinsic value of the company was close to 2 times the book value.
This premium would have to be written-off against earnings annually as shown in the table below:
Beginning Purchase-Premium Ending
Purchase Charge to Purchase
Year Premium Berkshire Earnings Premium
---- --------- ------------------ --------
(In $ Millions)
1986 ........... $142.6 $ 11.6 $131.0
1987 ........... 131.0 7.1 123.9
1988 ........... 123.9 7.9 115.9
1989 ........... 115.9 7.0 108.9
1990 ........... 108.9 7.1 101.9
1991 ........... 101.9 6.9 95.0
1992 ........... 95.0 7.7 87.2
1993 ........... 87.2 28.1 59.1
1994 ........... 59.1 4.9 54.2
By the end of 1994, the premium had been reduced to $54.2 million.
The change in book value, earnings and dividends of Scott Fetzer over the years is as follows:
(1) (4)
Beginning (2) (3) Ending
Year Book Value Earnings Dividends Book Value
---- ---------- -------- --------- ----------
(In $ Millions) (1)+(2)-(3)
1986 .......... $172.6 $ 40.3 $125.0 $ 87.9
1987 .......... 87.9 48.6 41.0 95.5
1988 .......... 95.5 58.0 35.0 118.6
1989 .......... 118.6 58.5 71.5 105.5
1990 .......... 105.5 61.3 33.5 133.3
1991 .......... 133.3 61.4 74.0 120.7
1992 .......... 120.7 70.5 80.0 111.2
1993 .......... 111.2 77.5 98.0 90.7
1994 .......... 90.7 79.3 76.0 94.0
Despite the book value remaining fairly constant, the earnings showed a steady increase. Consequently, the return on equity became extraordinary.
If you look at the carrying cost of Scott Fetzer on Berkshire’s books at the end of 1994, it has already been reduced to $148.2 million (54.2+94).
This amount is less than half their carrying cost at the point of purchase, yet the earnings was twice of what it was then.
This meant that the difference between Scott Fetzer’s intrinsic value and the carrying cost on Berkshire’s books has grown to quite huge at the end of 1994.
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