Berkshire Hathaway 2003 Annual Meeting Audience Question # 26

The intrinsic value of a business is “terribly important and very fuzzy”

Warren Buffett:

Number 3.

Audience Member:

Yes. Hello. Paul Tomasik. Thornton, Illinois.

Ben Graham and the model of value investing… I’d like to bring the discussion back to that.

And what’s interesting and exceptional about you, and Charlie, and Ben Graham, is the self- discipline. The incredible self-discipline.

And if you look at the model and try to think how to present it to teach others that self- discipline, I think you have to make a little tweak to it in two areas. And that’s what I’d like you to comment on.

One, intrinsic value. It’s always discussed that you calculate intrinsic value. But in practice, I think you find a number that is guaranteed… 99 percent likely… to be less than intrinsic value.

Classic example was in 2000 when you said you’d buy shares back at 45,000. You weren’t saying that Berkshire Hathaway’s intrinsic value was 45,000. You were saying it was significantly more. And anyone who bought it for less than 45,000 is grateful to you.

The other area is the hidden assumption in the model. And that is, it’s assumed that once you find a value stock and you buy it, that the intrinsic value isn’t going to go down. And that’s a second part of the analysis that has to be part of the discipline.

So even though you found a value stock, you still haven’t done all the work. You have to analyze, is the intrinsic value going to go down. In particular, companies throw away intrinsic value is the most common. Management gives it away.

That hasn’t happened at Berkshire Hathaway, although I don’t want to give an unqualified comment on that, since I see you’re remodeling the offices, so we don’t know how much intrinsic value’s been thrown away there.

So, if you could comment on the two things. Do you calculate intrinsic value, or a number that’s absolutely positivity under intrinsic value, that’s the number you put in the equation?

And even when you find a stock selling for less than this lower bound of intrinsic value, do you still do the homework on the second part and analyze, will the intrinsic value go down in the future? Thank you.

Warren Buffett:

Yeah, I would feel somewhat better qualified to speak on self-discipline if I weighed about 20 pounds less, but… for the moment we’ll ignore that.

The second part of your question, relating to intrinsic value going down. Actually, if you compute intrinsic value as reflecting the discounted value of future cash flows, that should have, built into it, a calculation that allows for the fact that certain businesses are going to earn less in the future than now.

It isn’t that their intrinsic value goes down then, because you should build it into your calculation right now.

But, you know, as we point out many times in the past, intrinsic value is terribly important and very fuzzy, and we do our best to work with… in the kind of businesses where we think that we have the highest probabilities… where our predictions are of a fairly highly probable nature. And that leaves out all kinds of companies.

It’s pretty good. We’ll say it’s something like a natural gas pipeline. I mean the chances of big surprises in a pipeline should be relatively small. That doesn’t mean they’re zero, but they’re relatively small.

Now, let’s assume that you had a gas pipeline, which some have, where either the supply of gas is going to run down or where there are competitive pipelines that may be trying to take away your contracts that you wrote 10 years ago and expire in two years and you’re going to have to cut prices.

I would say that two years from now, when you have to cut prices, the intrinsic value hasn’t gone down from today, if you properly calculate it today and build in the fact that profit margins in the future will be lower than today.

We looked at a pipeline recently where we think they are going to be vulnerable to competitive price pressures because of alternate ways of getting gas to market through other pipelines.

And the calculation is entirely different… the calculation isn’t different… the results are different, in terms of that pipeline versus the pipeline that is the low-cost way of delivering gas from one market to another, and will remain the low-cost producer.

But it isn’t… if properly calculated, you build in the prediction of decline in future operating years. You don’t wait till you get there to anticipate it.

You know, Charlie’s famous for saying that all he wants to know is where he’s going to die so he’ll never go there.

Well, that’s part of predicting in business. I mean, there… I love the… I really have never seen an investment banker’s book. I hope to see one someday, and I hope I can survive the shock when I do see it, where the earnings of the business being offered go down.

Lots of businesses’ earnings go down. And they’re going to go down. And I get all this nonsense, you know, where they project it out for 10 years and it always goes up. It just isn’t the real world.

And you have to analyze businesses… some businesses are going to be subjected to enormous competitive pressures that aren’t extant today.

And we made that mistake, for example, at Dexter Shoe. I mean we bought a business that was earning $40 million, or so, pretax.

And we assumed that the future would be as good as the past, and we couldn’t have been more… I couldn’t have been more wrong.

So that was a case of projecting into the future, conditions which were not going to exist in the future… competitive conditions.

That’s part of, you know, that’s part of business.

And I will tell you that, you know, 20 percent of the Fortune 500… but I don’t know which 20 percent… are going to be earning, you know, significantly less money probably five years from now than they are today.

And that’s what the game is all about. Figuring out what those future cash flows are likely to be. And when you can’t… when you feel you can’t come up with reasonable estimates in that respect, you move onto the next one.

Charlie?

Charlie Munger:

Yeah. We have this simple, old-fashioned discipline, which Warren likens to Ted Williams waiting for a fat pitch.

I don’t know about Warren, but if you said to me, “Charlie, you can go into the business of managing money the way other people do, where you’re measured against indexes and you got consultants choosing consultants that are reviewing you to committees,” I would just hate it.

I would regard it as being put into shackles. And shackles where the very system was preventing me from delivering value.

Warren, how would you feel about that…

Warren Buffett:

Yeah, we wouldn’t

Charlie Munger:

…chore?

Warren Buffett:

… do it. We wouldn’t do it. We never did do it, as a matter of fact.

And one of the, you know, the initial… when we formed the partnership on May 5th, 1956, I passed out to the seven limited partners something called the “ground rules.”

And, you know, I said, “Here’s what I can do and here’s what I can’t do. And here’s some things I don’t know whether I can do or not, maybe.” It was fairly short.

But the idea of setting out to do something that you know you can’t do, that can’t be… you know, that’s got to lead to problems.

I mean, if somebody tells me I have to high jump seven feet, and we could even move that down to four feet now… you know, between now and sundown or I’ll be shot, you know, I will go out and buy a bulletproof vest.

Charlie Munger:

Yeah, the general system for money management requires people to pretend that they can do something that they can’t do, and to pretend to like it when they really don’t. And I think that’s a terrible way to spend your life, but it’s very well paid.

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