Berkshire Hathaway 1994 Annual Meeting Audience Question # 72

How to calculate a company’s intrinsic value

Warren Buffett:

Zone 2?

Audience Member:

Thank you. Sean Barry, Regina, Canada.

Mr. Buffett, you’ve indicated that most of us in this room could acquire a lot of the information that you and Charlie acquire through the annual reports. Yet you both also indicated that the GAAP rules, a lot of times, leave a little to be desired.

Could you perhaps give an indication as to how you and Charlie come up with the economic value, or the intrinsic value, of the businesses that you finally decide to invest in? And a little bit about the process that you go through with that? Thank you.

Warren Buffett:

Well, the… in the 1992 annual report, we discuss that a fair amount.

But the economic value of any asset, essentially, is the present value, the appropriate interest rate, of all the future streams of cash going in or out of the business.

And there are all kinds of businesses that Charlie and I don’t think we have the faintest idea what that future stream will look like. And if we don’t have the faintest idea what the future stream is going to look like, we don’t have the faintest idea what it’s worth, now. Now that…

So, if you think you know what the price of a stock should be today, but you don’t think you have any idea what the stream of cash will be over the next 20 years, you’ve got cognitive dissonance, I guess, is what they call it. The…

So we are looking for things where we feel… fairly high degree of probability… that we can come within a range of looking at those numbers out over a period of time, and then we discount them back.

And we are more concerned with the certainty of those numbers than we are with getting the one that looks absolutely the cheapest, but based upon numbers that we don’t have any… we don’t have great confidence in.

And that’s basically what economic value is all about.

The numbers in any accounting report mean nothing, per se, as to economic value. They are guidelines to tell you something about how to get at economic value.

But they don’t tell you anything. It… there are no answers in the financial statements. There are guidelines to enable you to figure out the answer. And to figure out that answer, you have to understand something about business.

You don’t have to understand a lot about mathematics. I mean, the math is not complicated.

But you do have to understand something about the business.

But that’s the same thing you would do if you were going to buy an apartment house, or a farm, or any other small business you might be interested in.

You would try to figure out what you are laying out currently, and what you are likely to get back over time, and how certain you felt about getting it, and how it compared to other alternatives. That’s all we do, we just do it with large businesses, basically.

The accounting figures are very helpful to us, in the sense that they generally guide us to what we should be thinking about.

And of course, if we find numbers where it looks like people are taking the most optimistic interpretation of things that they can under GAAP and all of that, we get very worried about people who look like they massage the numbers in any way. And there are plenty of people that do.

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