In this post, I will look over the divergence in intrinsic and book value. This piece takes heavy inspiration from Warren Buffett’s 1994 Berkshire Hathaway Shareholder Letter.

The book value of a business is a number that is very easy to compute but it does have its limitations in use cases (best for banks & insurance). Unlike intrinsic value where it is impossible to calculate exactly and can be used for all businesses regardless of size or industry.

To clarify, I would define book value as the carrying value of the entire enterprise (share capital & retained earnings), which is the difference in total assets and total liabilities, its net worth. I would define intrinsic value as the discounted value of the cash distributable to owners throughout the course of the firm’s life.

The book and intrinsic values of a business can be very different. When a firm’s assets are due to produce little to no cash for owners in the future and the carrying value is more than liquidation value, the book value for the business will exceed the intrinsic value. On the other hand, when the carrying value of a firm’s assets are less than the cash benefits to owners in the future, the intrinsic value of the business exceeds the business’s book value.

In his letter to shareholders, Buffett uses the example of education (a form of investment) to explain the divergence of book & intrinsic value.

To get a figure for the intrinsic value of education, we would need to estimate the future earnings stream that a graduate would receive throughout the course of their lifetime and subtract that number by what they would’ve earned in their lifetime without a degree. The difference, discounted at the appropriate interest rate back to the day of graduation is the intrinsic economic value of education.

The cost of education should be thought of as the book value.

To evaluate whether or not the cost of education is worth it, prospectives should compare their book value to the intrinsic value of education. If the intrinsic value of education falls short of the book value, the student would not be getting their money’s worth and is better off getting a job than going to college. Some prospectives will find that their intrinsic value of education exceeds their book value, these people are far better off paying for their education and then getting employed. It is important to note that this calculation ignores the non-economic value of education that is a key factor in the decision making process for many.

In a more practical example, Buffett uses the example of Scott Fetzer (1986-1994), a Berkshire subsidiary. Acquired in 86′ Berkshire paid $315 million, a $142.6 million premium to book value. Back in the 90s, goodwill would be amortized (was changed in 01′ w/ some exceptions made in 14′), and was in the case of Scott Fetzer & Berkshire. In this example, Scott Fetzer’s carrying value on Berkshire’s books had shrunk down to $90.7 million but earnings had just short of doubled ($40.3M > $79.3M). Whilst the book value of Scott Fetzer was shrinking, the intrinsic value of the business was growing. The amortization costs of Scott Fetzer reduced Berkshire’s net worth & earnings but in truth, the intrinsic value growth strengthened the Berkshire enterprise.

In some cases, book value is a fair and useful indicator of business performance but it cannot be made out to be a substitute for intrinsic value. The calculation of intrinsic value is completely different to that of book value and far less precise. Book value is faithful to historical value, while intrinsic value fixates on future output. When evaluating possible investment opportunities, it is almost always appropriate to disregard book value for intrinsic value.