Question: How do you calculate intrinsic value?
Buffett: Intrinsic value is terribly important but very fuzzy. We try to work with businesses where we have fairly high probability of knowing what the future will hold. If you own a gas pipeline, not much is going to go wrong. Maybe a competitor enters forcing you to cut prices, but intrinsic value hasn’t gone down if you already factored this in. We looked at a pipeline recently that we think will come under pressure from other ways of delivering gas [to the area the pipeline serves]. We look at this differently from another pipeline that has the lowest costs [and does not face threats from alternative pipelines]. If you calculate intrinsic value properly, you factor in things like declining prices.
When we buy business, we try to look out and estimate the cash it will generate and compare it to the purchase price. We have to feel pretty good about our projections and then have a purchase price that makes sense. Over time, we’ve had more pleasant surprises than we would have expected.
I’ve never seen an investment banker’s book in which future earnings are projected to go down. But many businesses’ earnings go down. We made this mistake with Dexter shoes — it was earning $40 million pretax and I projected this would continue, and I couldn’t have been more wrong.
20% of Fortune 500 companies will be earning significant less in five years, but I don’t know which 20%. If you can’t come up with reasonable estimates for that, then you move on.
Source: BRK Annual Meeting 2003 Tilson Notes
Question: What do you believe to be the most important tools in determining intrinsic value? What rules or standards do you apply when using these tools?
Buffett: If we could see in looking at any business what its future cash flows would be for the next 100 years, and discount that back at an appropriate interest rate, that would give us a number for intrinsic value. It would be like looking at a bond that had a bunch of coupons on it that was due in a hundred years … Businesses have coupons too, the only problem is that they’re not printed on the instrument and it’s up to the investor to try to estimate what those coupons are going to be over time. In high-tech businesses, or something like that, we don’t have the faintest idea what the coupons are going to be. In the businesses where we think we can understand them reasonably well, we are trying to print the coupons out. If you attempt to assess intrinsic value, it all relates to cash flow. The only reason to put cash into any kind of investment now is that you expect to take cash out–not by selling it to somebody else, that’s just a game of who beats who–but by the asset itself … If you’re an investor, you’re looking on what the asset is going to do, if you’re a speculator, you’re commonly focusing on what the price of the object is going to do, and that’s not our game. We feel that if we’re right about the business, we’re going to make a lot of money, and if we’re wrong about the business, we don’t have any hopes of making money.
[Charlie Munger: I would argue that one filter that’s useful in investing is the idea of opportunity costs. If you have one idea that’s available in large quantity that’s better that 98% of the other opportunities, then you can just screen out the other 98% … With this attitude you get a concentrated portfolio, which we don’t mind. That practice of ours which is so simple is not widely copied, I don’t know why. Even at great universities and intellectual institutions. It’s an interesting question: If we’re right, why are so many other places so wrong.]
There are several possible answers to that question! (laughter) The first question we ask ourselves is, would we rather own this business than more Coca-Cola, than more Gillette …. We will want companies where the certainty gets close to that, or we would figure we’d be better off buying more Coke. If every management, before they bought a business, said is this better than buying in our own stock or even buying Coca-Cola stock, there’d be a lot less deals done. We try to measure against what we regard as close to perfection as we can get.
Source: BRK Annual Meeting 1997
Buffett: Intrinsic value is simply the sum of all future cash flows a business generates between now and judgment day, discounted back at the proper rate. But that’s pretty nebulous. To value the businesses we own presently, we try to give you information to make a reasonable judgment about that. We own securities, which are easy to value, and operating businesses. We try to give you the information we use to value them.
Since Berkshire retains all of its earnings, it becomes very important to evaluate what we’ll do with earnings over time.
If you’d looked at the intrinsic value of Berkshire in 1965, we had a textile business worth $12 [per share], but that wasn’t all. You had to evaluate not only the business, but also the skill with which retained earnings would be used.
It’s the same situation today: we will put to work billions of dollars this year and in the future. If we do this effectively, each dollar has a value of more than $1. We have $80,000 [per share] in marketable securities. If our insurance business breaks even, that’s free to us. We’re trying to add to our collection of operating businesses and they’ll add to earnings.
If Charlie and I wrote down our estimates of Berkshire’s intrinsic value, they wouldn’t be exactly the same, but they would be close.
Source: BRK Annual Meeting 2007 Tilson Notes