Everyone wants to invest like Buffett, and while understanding things like his rules for running a business, investing mindset, personality traits, and even his morning routine can help you better understand the genius that is the Oracle of Omaha, there is way more to studying Buffett’s investing stratagems than simply reading quotes on the internet. In fact, much of Buffett’s wisdom comes from his unique understanding of accounting and financial principles and ideas.
One of those ideas which seems to be mostly overlooked is the importance of intrinsic value over book value. Buffett, in his annual shareholder letters, often writes how he and his partner Charlie Munger rarely measure companies based on their book value. Intrinsic value, instead, is the most important part of making a decision.
Defining Book Value and Intrinsic Value
Here are the definitions of each, according to Investopedia.
Intrinsic Value – The intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value.
Book Value – Book value of an asset is the value at which the asset is carried on a balance sheet and calculated by taking the cost of an asset minus the accumulated depreciation. Book value is also the net asset value of a company, calculated as total assets minus intangible assets (patents, goodwill) and liabilities.
If that’s a little too complicated for you, then fortunately Buffett has simplified it.
“Book value tells you what has been put in; intrinsic business value estimates what can be taken out,” Buffett wrote in the 1983 Shareholder Letter.
While both are important, by far the most important of the two is the intrinsic value. While a company might currently be in the positive as far as book value goes, if there is not enough actual intrinsic value to the company, then the investment will not pay off in the long term. And, if you want to invest like Buffett, you have to think about things for the long term.
However, that being said it’s important not to entirely write off book value. After all, book value is one of the many ways to measure intrinsic value. Book value and intrinsic value have to be considered together. Buffett explained this perfectly in his 1983 Shareholder letter:
“We report our progress in terms of book value because in our case (though not, by any means, in all cases) it is a conservative but reasonably adequate proxy for growth in intrinsic business value – the measurement that really counts.”