Warren Buffett Explains How To Calculate Intrinsic Value Of A Stock

Yeah, the actually Graham didn't get too specific about intrinsic value in terms of precise calculations, but intrinsic value has come to be equated with, and I think quite properly with, what you might call private business value. Now, I'm not sure who was the first one that came up with it, but well, the first one I came up with it was ESOP actually.

But uh, the intrinsic value of any business, if you could foresee the future perfectly, is the present value of all cash that will be ever distributed for that business between now and Judgment Day. We're not perfect at estimating that, obviously, but that is what an investment or a business is all about. You put money in and you take money out. ESOP said, "A burden in the hand is worth two in the bush." Now, I said that around 600 BC or something like that, but that hasn't been improved on very much by the business professors.

Now, the question is, you know, how sure are you that there are two in the bush? You know, how far away is the bush? There are all kinds of things, what are interest rates? But I mean, ESOP wanted to leave us something to play with over the next couple thousand years, so he didn't spell the whole thing out. But that's what intrinsic value essentially is.

And uh, we don't... Graham would say that Phil Fisher would say that... Phil Fisher would say that in calculating that, he would want to look a lot harder at the qualitative factors of the business in making that estimate of how many birds were in the bush. Graham would say he would want to see the bush, you know, two dollars' worth of cash in the bush, you know, and to pay a dollar for it now.

What emphasized quantitative factors, and want to emphasize qualitative factors, but neither one would have disagreed with the math. I started out very influenced by Graham, so I emphasize quantitative factors. Charlie came along and said I was all wrong and that he learned more in law than I'd learned in financial studies and everything, and that I should think more about qualitative factors. And he was right. Phil Fisher said the same thing.

But that's what intrinsic value is about, you know. If you buy a McDonald's franchise, if you buy General Motors, whatever it may be, the real question is, hey, are you going to have to put more cash into it after you buy it? But it's really cash in, cash out—what discount rate, all the standard stuff that...

In terms of us, if I had a silver bullet, what company would I shoot as being a threat to us? I don't really... I don't see any competitor to Berkshire. I see private equity buying lots of businesses and having an advantage in that they'll leverage up when we won't.

Also, they can borrow money very cheap, and all of that. So, I mean, there are always going to be people competing with us to buy businesses, but... and which is our main business, the main occupation for me and Charlie. But I don't think I see anybody that's got a model or trying to buy—build a model that will essentially go after what we're trying to achieve, which is to buy wonderful businesses from people that care about where their business goes and who generally want to keep on running them.

Dearly, well, as I said earlier, I think the Berkshire model has now constructed, will have made, instead of show business with legs, it will go a long time. I think it will be quite creditable and I think it has enough advantage that it will just keep going a long time.

I don't think most big businesses—don't you stop to think about it—all the great big businesses of yesteryear? How few of them have really gotten big and stayed big? Of the really old businesses, only one stayed big, and that was Rockefeller's Standard Oil. So, you're getting up into a territory where very few people keep going.

Well, but I think we more like Standard Oil and we'll be like ordinary businesses, because I think we will just keep going. We will keep doing what we're already doing and we'll keep learning from our mistakes, and the people up here are no longer all that important.

The momentum's in place, the ethos is in place, it's going to keep going. And if, are you young people in the audience, I always say, don't be too quick to sell those thoughts. Why don't we get more copycats? It reminds me of our mutual friend Ed Davis. He figured out how to do an operation that was so difficult that he operated at the bottom of a dark hole with instruments of his own creation.

He gave his own shots by novocaine—87 of them—while he was operating, and it was a better operation. His death rate was 2 percent, and everybody else was 20. The other surgeons came to copy him, and they watched him, and I just said, "Well, I don't think I'll try and copy that; I think it looks just too hard to do."

There's nothing in the American business school that teaches people to be like Berkshire. Eddie Davis is the guy that in effect introduced the two of us. He was a famous urologist here in Omaha, and the people didn't try and learn these operations. It doesn't look all that easy; it's very different.

It's slow too, and it's slow—it's very slow. I think the slowness deters more people than anything else. That and the difficulty with being slow is, you’re dead before it’s finished.

Well, that's kind of cheerful, Carol. Let's come up with something a little... The intrinsic value question. I mean, by definition, intrinsic value is the present value of the stream of cash that's going to be generated by any financial asset between now and doomsday. And that's easy to say and impossible to figure, but it's the kind of thing that we're looking at when we look at a Coca-Cola, where we think it's much easier to evaluate the stream of cash that comes in the future than it is in a company such as Intel.

Marvelous as it may be, we just... it's easier for us. It may not... Andy Grove may be better at figuring out Intel than Coke, and Berkshire.

It is complicated by the fact that we have no business that naturally employs all of the capital that flows to us. So, it is dependent to some extent, uh, on the opportunities available and the ingenuity used in when that cash pours in, as it does. Some businesses have a natural use for the cash—actually, Intel has a good natural use for the cash over time as they've expanded in their business, and many businesses do.

But we do not have a natural use. We have some businesses that use significant amounts of cash, or Flight Safety will buy a lot of... build a lot of simulators this year, and they cost real money. But in relation to the resources available, we have to come up with new uses, new ways to use cash, and that makes for a more difficult valuation job than if you've got...

Well, the classic case used to be a water or electric utility, where the cash could be deployed and the return was more or less guaranteed within a narrow range. It was very easy to make calculations then as to the expectable returns in the future, but that's not the case at Berkshire.

We've got very good businesses, both directly and partially owned, and those businesses are going to do well for a long, long time. But we do have new cash coming out all the time, and sometimes we have good ideas for that cash, and sometimes we don't. And that does make your job more difficult in terms of computing intrinsic value.