ValueWalk

From The Archives: Warren Buffett On Intrinsic Value [Pt. 1]

Warren Buffett, the Oracle of Omaha, has built a fortune of more than $80 billion over his career thanks to his stock picking skill, and a little luck.

See also: Hidden Value Stocks, Up 28% On Average

Buffett first began investing in his early teenage years, and ever since, his strategy has evolved and developed thanks to his increasing experience. However, the one idea that has formed part of Buffett’s strategy since the beginning is the idea of a company’s intrinsic value.

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Estimating a company’s intrinsic value has been the core of Buffett’s strategy for decades. So, I thought it would be interesting to go back through his letters to shareholders of Berkshire Hathaway written over the years to gather some insight into how Buffett sees and calculates a company’s intrinsic value.

Warren Buffett Intrinsic Value Is Key

I’m going to start with this quote from Berkshires 1992 letter to investors:

“You will remember that our goal is to increase our per-share intrinsic value - for which our book value is a conservative, but useful, proxy - at a 15% annual rate.  This objective, however, cannot be attained in a smooth manner.  Smoothness is particularly elusive because of the accounting rules that apply to the common stocks owned by our insurance companies, whose portfolios represent a high proportion of Berkshire's net worth. Since 1979, generally accepted accounting principles (GAAP) have required that these securities be valued at their market prices (less an adjustment for tax on any net unrealized appreciation) rather than at the lower of cost or market.  Run-of-the-mill fluctuations in equity prices, therefore, cause our annual results to gyrate, especially in comparison to those of the typical industrial company.”

Here Buffett makes it clear that intrinsic value is not a precise art, nor is it predictable. Building value takes many years and plenty of skill. The patient will be well rewarded as intrinsic value growth compounds over time.

Next, we move on to a letter to shareholders written in 1994. These quotes are taken from a section on stock repurchases. Buffett is discussing the benefits, and drawbacks of buying back stock at certain levels and the importance of managers to understand the notion of intrinsic value before buying.  

“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.

In corporate transactions, it's equally silly for the would-be purchaser to focus on current earnings when the prospective acquirer 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.”

Unfortunately, the notion of intrinsic value tends to allude most managers and this means that they create an imbalance for investors.

“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 honeypot 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." -- 1994 Letter to shareholders.

The 1994 letter to investors isn’t the only time Buffett has discussed repurchases. In 1999 he again broached the topic when discussing whether or not Berkshire would be buying back stock anytime soon:

“There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down.

Charlie and I admit that we feel confident in estimating the intrinsic value for only a portion of traded equities and then only when we employ a range of values, rather than some pseudo-precise figure.” --- 1999 letter to shareholders

What I like about this quote is that Buffett is giving us some insight into his investing process. He says he likes to estimate value with a “range of values” rather than some “pseudo-precise figure,” giving a hat tip to Benjamin Graham’s margin of safety principle.

And from 2013, here is some guidance from Buffett on how he hopes to build Berkshire’s intrinsic value over the years.

“With this tailwind working for us, Charlie and I hope to build Berkshire’s per-share intrinsic value by (1) constantly improving the basic earning power of our many subsidiaries; (2) further increasing their earnings through bolt-on acquisitions; (3) benefiting from the growth of our investees; (4) repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value; and (5) making an occasional large acquisition. We will also try to maximize results for you by rarely, if ever, issuing Berkshire shares.” -- Letter to shareholders 2013