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
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.

Posted: Mar 27, 2001

1 comment:

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