Thursday, April 26, 2012

Buffett: Intrinsic Value vs Book Value

From Warren Buffett's 1998 Berkshire Hathaway (BRKa) shareholder letter:

Our stock sells at a large premium over book value, which means that any issuing of shares we do -- whether for cash or as consideration in a merger -- instantly increases our per-share book value figure, even though we've earned not a dime. What happens is that we get more per-share book value in such transactions than we give up. These transactions, however, do not deliver us any immediate gain in per-share intrinsic value...

It is gains in per-share intrinsic value that really matters. Here's how Buffett explains intrinsic value and book value in the Berkshire Hathaway owner's manual:

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.

Buffett later adds the following:

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.

The per share book value of Berkshire Hathaway Class A shares at the end of 2011 was $99,860/share while the share price is at $ 119,756 (or a 19.9% premium). Now, Buffett consistently makes the point that it only makes sense to repurchase shares when a company is in a comfortable financial position and the shares are selling at a substantial discount to intrinsic value.

In September of last year, Buffett and the Board of Directors obviously believed that was the case for Berkshire and decided it made sense to establish a formal repurchase program:

Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares. In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise.

So that certainly provides some rough guidance as to when they think a sufficient enough discount to value exists that it warrants the repurchase of shares.

If the shares are selling at a 10% premium over the book value** or less, Buffett and the Board have now made it clear they think it represents quite a nice discount to what Berkshire's shares are worth intrinsically.***

When they announced the repurchase program, the prior trading day's closing price of Berkshire's Class A shares was $103,320 (or very close to dead even with book value).

Well, since the shares have rallied quite a bit since then, it would seem they are no longer low enough for repurchase.

Probably not, but it's worth keeping in mind that the book value is a moving target and has likely increased since the end of last year.

That makes the phrase "then-current book value" used by Buffett in the share repurchase announcement rather important. When Berkshire's results are released for the 1st quarter, we'll get to see if and by how much book value (Berkshire's inadequate yet useful tracking measure) has increased.

Check out page 99-100 of the 2011 annual report for a good explanation of how Buffett and Munger view Berkshire's intrinsic value.

Adam

Long position in BRKb established at lower than recent market prices

* From the letter: All figures used in this report apply to Berkshire's A shares, the successor to the only stock that the company had outstanding before 1996. The B shares have an economic interest equal to 1/30th that of the A. 
[Well, it was 1/30th back then but now is 1/1500th as explained in this memo.]
** 10% premium over the book value or 110% of the book value. It's been described both ways in different publications.
*** If selling at more than a 10% premium over book value, the stock may still sell at a discount to intrinsic value but not enough of one to warrant buying. How it competes with other investing alternatives also always comes into play and Buffett says as much in the share repurchase announcement.
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