http://www.jamesaltucher.

com/2011/03/8-unusual-things-i-learned-fromwarren-buffett/
http://finance.yahoo.com/news/guru-francis-chou-answers-readers001331315.html

INTRINSIC VALUE (1996, Berkshire Hathaways Letter to Shareholders)

Now let's focus on two terms that I mentioned earlier and that you will
encounter in future annual reports.
Let's start with intrinsic value, 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, moreover - and this would apply even to Charlie and me - will
almost inevitably come up with at least slightly different intrinsic value
figures. That is one reason we never give you our estimates of intrinsic
value. What our annual reports do supply, though, are the facts that we
ourselves use to calculate this value.
Meanwhile, we regularly report our per-share book value, an easily
calculable number, though one of limited use. The limitations do not arise
from our holdings of marketable securities, which are carried on our books
at their current prices. Rather the inadequacies of book value have to do with
the companies we control, whose values as stated on our books may be far
different from their intrinsic values.
The disparity can go in either direction. For example, in 1964 we could state
with certitude that Berkshire's per-share book value was $19.46. However,
that figure considerably overstated the company's intrinsic value, since all of
the company's resources were tied up in a sub-profitable textile business.
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Our textile assets had neither going-concern nor liquidation values

equal to their carrying values. Today, however, Berkshire's situation is
reversed: Now, our book value far understates Berkshire's intrinsic value, a
point true because many of the businesses we control are worth much more
than their carrying value.
Inadequate though they are in telling the story, we give you Berkshire's
book-value figures because they today serve as a rough, albeit significantly
understated, tracking measure for Berkshire's intrinsic value. In other words,
the percentage change in book value in any given year is likely to be
reasonably close to that year's change in intrinsic value.
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.
-1985
Historically, Berkshire shares have sold modestly below intrinsic business
value. With the price there, purchasers could be certain (as long as they did
not experience a widening of this discount) that their personal investment
experience would at least equal the financial experience of the business. But
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recently the discount has disappeared, and occasionally a modest premium

has prevailed.
The elimination of the discount means that Berkshires market value
increased even faster than business value (which, itself, grew at a pleasing
pace). That was good news for any owner holding while that move took
place, but it is bad news for the new or prospective owner. If the financial
experience of new owners of Berkshire is merely to match the future
financial experience of the company, any premium of market value over
intrinsic business value that they pay must be maintained.
Management cannot determine market prices, although it can, by its
disclosures and policies, encourage rational behavior by market participants.
My own preference, as perhaps youd guess, is for a market price that
consistently approximates business value. Given that relationship, all
owners prosper precisely as the business prospers during their period of
ownership. Wild swings in market prices far above and below business
value do not change the final gains for owners in aggregate; in the end,
investor gains must equal business gains. But long periods of substantial
undervaluation and/or overvaluation will cause the gains of the business to
be inequitably distributed among various owners, with the investment result
of any given owner largely depending upon how lucky, shrewd, or foolish he
happens to be.
Over the long term there has been a more consistent relationship between
Berkshires market value and business value than has existed for any other
publicly-traded equity with which I am familiar. This is a tribute to you.
Because you have been rational, interested, and investment-oriented, the
market price for Berkshire stock has almost always been sensible. This
unusual result has been achieved by a shareholder group with unusual
demographics: virtually all of our shareholders are individuals, not
institutions. No other public company our size can claim the same.
You might think that institutions, with their large staffs of highlypaid and experienced investment professionals, would be a force for
stability and reason in financial markets. They are not: stocks heavily
owned and constantly monitored by institutions have often been among
the most inappropriately valued.

Ben Graham told a story 40 years ago that illustrates why investment
professionals behave as they do: An oil prospector, moving to his heavenly
reward, was met by St. Peter with bad news. Youre qualified for
residence, said St. Peter, but, as you can see, the compound reserved for
oil men is packed.
Theres no way to squeeze you in. After thinking a moment, the prospector
asked if he might say just four words to the present occupants. That seemed
harmless to St. Peter, so the prospector cupped his hands and yelled, Oil
discovered in hell. Immediately the gate to the compound opened and all of
the oil men marched out to head for the nether regions. Impressed, St. Peter
invited the prospector to move in and make himself comfortable. The
prospector paused. No, he said, I think Ill go along with the rest of the
boys. There might be some truth to that rumor after all.
-2000
Indeed, the formula for valuing all assets that are purchased for financial
gain has been unchanged since it was first laid out by a very smart man in
about 600 B.C. (though he wasnt smart enough to know it was 600 B.C.).
The oracle was Aesop and his enduring, though somewhat incomplete,
investment insight was "a bird in the hand is worth two in the bush." To flesh
out this principle, you must answer only three questions. How certain are
you that there are indeed birds in the bush? When will they emerge and how
many will there be? What is the risk-free interest rate (which we consider to
be the yield on long-term U.S. bonds)? If you can answer these three
questions, you will know the maximum value of the bush and the
maximum number of the birds you now possess that should be offered for it.
And, of course, dont literally think birds. Think dollars.
Aesops investment axiom, thus expanded and converted into dollars, is
immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery
tickets, and manufacturing plants. And neither the advent of the steam
engine, the harnessing of electricity nor the creation of the automobile
changed the formula one iota nor will the Internet. Just insert the correct
numbers, and you can rank the attractiveness of all possible uses of capital
throughout the universe.

Common yardsticks such as dividend yield, the ratio of price to

earnings or to book value, and even growth rates have nothing to do
with valuation except to the extent they provide clues to the amount and
timing of cash flows into and from the business. Indeed, growth can
destroy value if it requires cash inputs in the early years of a project or
enterprise that exceed the discounted value of the cash that those assets will
generate in later years. Market commentators and investment managers who
glibly refer to "growth" and "value" styles as contrasting approaches to
investment are displaying their ignorance, not their sophistication. Growth is
simply a component usually a plus, sometimes a minus in the value
equation.
Alas, though Aesops proposition and the third variable that is, interest
rates are simple, plugging in numbers for the other two variables is a
difficult task. Using precise numbers is, in fact, foolish; working with a
range of possibilities is the better approach.
Usually, the range must be so wide that no useful conclusion can be
reached. Occasionally, though, even very conservative estimates about the
future emergence of birds reveal that the price quoted is startlingly low in
relation to value. (Lets call this phenomenon the IBT Inefficient Bush
Theory.) To be sure, an investor needs some general understanding of
business economics as well as the ability to think independently to reach a
well-founded positive conclusion. But the investor does not need brilliance
nor blinding insights.
At the other extreme, there are many times when the most brilliant of
investors cant muster a conviction about the birds to emerge, not even when
a very broad range of estimates is employed. This kind of uncertainty
frequently occurs when new businesses and rapidly changing industries are
under examination. In cases of this sort, any capital commitment must be
labeled speculative.
Now, speculation in which the focus is not on what an asset will
produce but rather on what the next fellow will pay for it is neither illegal,
immoral nor un-American. But it is not a game in which Charlie and I wish
to play. We bring nothing to the party, so why should we expect to take
anything home?

The line separating investment and speculation, which is never bright and
clear, becomes blurred still further when most market participants have
recently enjoyed triumphs. Nothing sedates rationality like large doses of
effortless money. After a heady experience of that kind, normally sensible
people drift into behavior akin to that of Cinderella at the ball. They know
that overstaying the festivities that is, continuing to speculate in
companies that have gigantic valuations relative to the cash they are likely to
generate in the future will eventually bring on pumpkins and mice. But
they nevertheless hate to miss a single minute of what is one helluva party.
Therefore, the giddy participants all plan to leave just seconds before
midnight. Theres a problem, though: They are dancing in a room in which
the clocks have no hands.
Last year, we commented on the exuberance and, yes, it was irrational
that prevailed, noting that investor expectations had grown to be several
multiples of probable returns. One piece of evidence came from a Paine
Webber-Gallup survey of investors conducted in December 1999, in which
the participants were asked their opinion about the annual returns investors
could expect to realize over the decade ahead. Their answers averaged 19%.
That, for sure, was an irrational expectation: For American business as a
whole, there couldnt possibly be enough birds in the 2009 bush to deliver
such a return.
Far more irrational still were the huge valuations that market participants
were then putting on businesses almost certain to end up being of modest or
no value. Yet investors, mesmerized by soaring stock prices and ignoring all
else, piled into these enterprises. It was as if some virus, racing wildly
among investment professionals as well as amateurs, induced hallucinations
in which the values of stocks in certain sectors became decoupled from the
values of the businesses that underlay them.
This surreal scene was accompanied by much loose talk about "value
creation." We readily acknowledge that there has been a huge amount of true
value created in the past decade by new or young businesses, and that there
is much more to come. But value is destroyed, not created, by any business
that loses money over its lifetime, no matter how high its interim valuation
may get.
What actually occurs in these cases is wealth transfer, often on a massive
scale. By shamelessly merchandising birdless bushes, promoters have in

recent years moved billions of dollars from the pockets of the public to their
own purses (and to those of their friends and associates). The fact is that a
bubble market has allowed the creation of bubble companies, entities
designed more with an eye to making money off investors rather than for
them. Too often, an IPO, not profits, was the primary goal of a companys
promoters. At bottom, the "business model" for these companies has been
the old-fashioned chain letter, for which many fee-hungry investment
bankers acted as eager postmen.
But a pin lies in wait for every bubble. And when the two eventually
meet, a new wave of investors learns some very old lessons: First, many in
Wall Street a community in which quality control is not prized will sell
investors anything they will buy. Second, speculation is most dangerous
when it looks easiest.
At Berkshire, we make no attempt to pick the few winners that will
emerge from an ocean of unproven enterprises. Were not smart enough to
do that, and we know it. Instead, we try to apply Aesops 2,600-year-old
equation to opportunities in which we have reasonable confidence as to how
many birds are in the bush and when they will emerge (a formulation that
my grandsons would probably update to "A girl in a convertible is worth five
in the phonebook."). Obviously, we can never precisely predict the timing of
cash flows in and out of a business or their exact amount. We try, therefore,
to keep our estimates conservative and to focus on industries where business
surprises are unlikely to wreak havoc on owners. Even so, we make many
mistakes: Im the fellow, remember, who thought he understood the future
economics of trading stamps, textiles, shoes and second-tier department
stores.
Lately, the most promising "bushes" have been negotiated transactions
for entire businesses, and that pleases us. You should clearly understand,
however, that these acquisitions will at best provide us only reasonable
returns. Really juicy results from negotiated deals can be anticipated only
when capital markets are severely constrained and the whole business world
is pessimistic. We are 180 degrees from that point.