Sunday, April 30, 2006

Intrinsic value Vs. Book Value

Valuation of business is key to investing. When

you purchase a stock you are buying a piece of a

business which has certain economic value. But the price of

this piece of business namely market price of stock

fluctuates around this value due to variation in demand and

supply. To quote Warren Buffet ‘Price is what you pay, value

is what you get’. This means that unless you know

about valuation you can never be sure about what you

are getting for your dollar. The most important

concept in valuation of business is the intrinsic

value. In the long term buying stocks below their

intrinsic value is the most successful strategy. In my

effort to demystify equity investing I’m posting

excerpts from a letter of Warren Buffet where he has

explained this all important concept. Warren E. Buffet on Intrinsic value: 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, will almost inevitably

come up with at least slightly different intrinsic

value figures. You can gain some insight into the

differences between book value and intrinsic value by looking

at one form of investment, a college education.

Think of the education’s cost as its book value. If

this cost is to be accurate, it 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