Warren Buffet on Book Value vs Intrinsic Value, from Berkshire Hathaway
1994 Letter to Shareholders:
We regularly report our per-share book value, an easily
calculable number, though one of limited use. Just as regularly,
we tell you that what counts is intrinsic value, a number that is
impossible to pinpoint but essential to estimate.
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 stock'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. In 1964,
then, anyone inquiring into the soundness of Berkshire's balance
sheet might well have deserved the answer once offered up by a
Hollywood mogul of dubious reputation: "Don't worry, the
liabilities are solid."
Today, Berkshire's situation has reversed: Many of the
businesses we control are worth far more than their carrying
value. (Those we don't control, such as Coca-Cola or Gillette,
are carried at current market values.) We continue to give you
book value figures, however, because they serve as a rough,
albeit significantly understated, tracking measure for Berkshire's
intrinsic value. Last year, in fact, the two measures moved in
concert: Book value gained 13.9%, and that was the approximate
gain in intrinsic value also.
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.
Now let's get less academic and look at Scott Fetzer, an
example from Berkshire's own experience. This account will not
only illustrate how the relationship of book value and intrinsic
value can change but also will provide an accounting lesson that
I know you have been breathlessly awaiting. Naturally, I've
chosen here to talk about an acquisition that has turned out to
be a huge winner.
Berkshire purchased Scott Fetzer at the beginning of 1986.
At the time, the company was a collection of 22 businesses, and
today we have exactly the same line-up - no additions and no
disposals. Scott Fetzer's main operations are World Book, Kirby,
and Campbell Hausfeld, but many other units are important
contributors to earnings as well.
We paid $315.2 million for Scott Fetzer, which at the time
had $172.6 million of book value. The $142.6 million premium we
handed over indicated our belief that the company's intrinsic
value was close to double its book value.
In the table below we trace the book value of Scott Fetzer,
as well as its earnings and dividends, since our purchase.
(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
Because it had excess cash when our deal was made, Scott
Fetzer was able to pay Berkshire dividends of $125 million in
1986, though it earned only $40.3 million. I should mention that
we have not introduced leverage into Scott Fetzer's balance
sheet. In fact, the company has gone from very modest debt when
we purchased it to virtually no debt at all (except for debt used
by its finance subsidiary). Similarly, we have not sold plants
and leased them back, nor sold receivables, nor the like.
Throughout our years of ownership, Scott Fetzer has operated as a
conservatively-financed and liquid enterprise.
As you can see, Scott Fetzer's earnings have increased
steadily since we bought it, but book value has not grown
commensurately. Consequently, return on equity, which was
exceptional at the time of our purchase, has now become truly
extraordinary. Just how extraordinary is illustrated by
comparing Scott Fetzer's performance to that of the Fortune 500,
a group it would qualify for if it were a stand-alone company.
Had Scott Fetzer been on the 1993 500 list - the latest
available for inspection - the company's return on equity would
have ranked 4th. But that is far from the whole story. The top
three companies in return on equity were Insilco, LTV and Gaylord
Container, each of which emerged from bankruptcy in 1993 and none
of which achieved meaningful earnings that year except for those
they realized when they were accorded debt forgiveness in
bankruptcy proceedings. Leaving aside such non-operating
windfalls, Scott Fetzer's return on equity would have ranked it
first on the Fortune 500, well ahead of number two. Indeed,
Scott Fetzer's return on equity was double that of the company
ranking tenth.
You might expect that Scott Fetzer's success could only be
explained by a cyclical peak in earnings, a monopolistic
position, or leverage. But no such circumstances apply. Rather,
the company's success comes from the managerial expertise of CEO
Ralph Schey, of whom I'll tell you more later.
First, however, the promised accounting lesson: When we
paid a $142.6 million premium over book value for Scott Fetzer,
that figure had to be recorded on Berkshire's balance sheet.
I'll spare you the details of how this worked (these were laid
out in an appendix to our 1986 Annual Report) and get to the
bottom line: After a premium is initially recorded, it must in
almost all cases be written off over time through annual charges
that are shown as costs in the acquiring company's earnings
statement.
The following table shows, first, the annual charges
Berkshire has made to gradually extinguish the Scott Fetzer
acquisition premium and, second, the premium that remains on our
books. These charges have no effect on cash or the taxes we pay,
and are not, in our view, an economic cost (though many
accountants would disagree with us). They are merely a way for
us to reduce the carrying value of Scott Fetzer on our books so
that the figure will eventually match the net worth that Scott
Fetzer actually employs in its business.
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
Note that by the end of 1994 the premium was reduced to
$54.2 million. When this figure is added to Scott Fetzer's year-
end book value of $94 million, the total is $148.2 million, which
is the current carrying value of Scott Fetzer on Berkshire's
books. That amount is less than half of our carrying value for
the company when it was acquired. Yet Scott Fetzer is now
earning about twice what it then did. Clearly, the intrinsic
value of the business has consistently grown, even though we have
just as consistently marked down its carrying value through
purchase-premium charges that reduced Berkshire's earnings and
net worth.
The difference between Scott Fetzer's intrinsic value and
its carrying value on Berkshire's books is now huge. As I
mentioned earlier - but am delighted to mention again - credit
for this agreeable mismatch goes to Ralph Schey, a focused, smart
and high-grade manager.
The reasons for Ralph's success are not complicated. Ben
Graham taught me 45 years ago that in investing it is not
necessary to do extraordinary things to get extraordinary
results. In later life, I have been surprised to find that this
statement holds true in business management as well. What a
manager must do is handle the basics well and not get diverted.
That's precisely Ralph's formula. He establishes the right goals
and never forgets what he set out to do. On the personal side,
Ralph is a joy to work with. He's forthright about problems and
is self-confident without being self-important.
He is also experienced. Though I don't know Ralph's age, I
do know that, like many of our managers, he is over 65. At
Berkshire, we look to performance, not to the calendar. Charlie
and I, at 71 and 64 respectively, now keep George Foreman's
picture on our desks. You can make book that our scorn for a
mandatory retirement age will grow stronger every year.
Intrinsic Value and Capital Allocation
Understanding intrinsic value is as important for managers
as it is for investors. When managers are making capital
allocation decisions - including decisions to repurchase shares -
it's vital that they act in ways that increase per-share
intrinsic value and avoid moves that decrease it. This principle
may seem obvious but we constantly see it violated. And, when
misallocations occur, shareholders are hurt.
For example, in contemplating business mergers and
acquisitions, many managers tend to focus on whether the
transaction is immediately dilutive or anti-dilutive to earnings
per share (or, at financial institutions, to per-share book
value). An emphasis of this sort carries great dangers. Going
back to our college-education example, imagine that a 25-year-old
first-year MBA student is considering merging his future economic
interests with those of a 25-year-old day laborer. The MBA
student, a non-earner, would find that a "share-for-share" merger
of his equity interest in himself with that of the day laborer
would enhance his near-term earnings (in a big way!). But what
could be sillier for the student than a deal of this kind?
In corporate transactions, it's equally silly for the would-
be purchaser to focus on current earnings when the prospective
acquiree has either different prospects, different amounts of
non-operating assets, or a different capital structure. At
Berkshire, we have rejected many merger and purchase
opportunities that would have boosted current and near-term
earnings but that would have reduced per-share intrinsic value.
Our approach, rather, has been to follow Wayne Gretzky's advice:
"Go to where the puck is going to be, not to where it is." As a
result, our shareholders are now many billions of dollars richer
than they would have been if we had used the standard catechism.
The sad fact is that most major acquisitions display an
egregious imbalance: They are a bonanza for the shareholders of
the acquiree; they increase the income and status of the
acquirer's management; and they are a honey pot for the
investment bankers and other professionals on both sides. But,
alas, they usually reduce the wealth of the acquirer's shareholders,
often to a substantial extent. That happens because the acquirer
typically gives up more intrinsic value than it receives. Do that
enough, says John Medlin, the retired head of Wachovia Corp., and
"you are running a chain letter in reverse."
Over time, the skill with which a company's managers
allocate capital has an enormous impact on the enterprise's
value. Almost by definition, a really good business generates
far more money (at least after its early years) than it can use
internally. The company could, of course, distribute the money
to shareholders by way of dividends or share repurchases. But
often the CEO asks a strategic planning staff, consultants or
investment bankers whether an acquisition or two might make
sense. That's like asking your interior decorator whether you
need a $50,000 rug.
The acquisition problem is often compounded by a biological
bias: Many CEO's attain their positions in part because they
possess an abundance of animal spirits and ego. If an executive
is heavily endowed with these qualities - which, it should be
acknowledged, sometimes have their advantages - they won't
disappear when he reaches the top. When such a CEO is encouraged
by his advisors to make deals, he responds much as would a
teenage boy who is encouraged by his father to have a normal sex
life. It's not a push he needs.
Some years back, a CEO friend of mine - in jest, it must be
said - unintentionally described the pathology of many big deals.
This friend, who ran a property-casualty insurer, was explaining
to his directors why he wanted to acquire a certain life
insurance company. After droning rather unpersuasively through
the economics and strategic rationale for the acquisition, he
abruptly abandoned the script. With an impish look, he simply
said: "Aw, fellas, all the other kids have one."
At Berkshire, our managers will continue to earn
extraordinary returns from what appear to be ordinary businesses.
As a first step, these managers will look for ways to deploy
their earnings advantageously in their businesses. What's left,
they will send to Charlie and me. We then will try to use those
funds in ways that build per-share intrinsic value. Our goal
will be to acquire either part or all of businesses that we
believe we understand, that have good, sustainable underlying
economics, and that are run by managers whom we like, admire and
trust.
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