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March 7, 2005
Buffett on intangibles
In his annual report to shareholders (see yesterday's posting). Warren Buffett opened with a reference to "intrinsic value" and referred reader to his Owner's Manual. An abbreviated version of the Owner's Manual is available at Berkshire Hathaway's website. The concept of intrinsic value is central to Buffett's investment philosophy.
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.
This concept neatly side-steps the question of accounting for intangible assets by focusing on the ultimate output of the assets, rather than their current market value (if any). The following example illustrates the point:
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.
That last quote - "book value is meaningless as an indicator of intrinsic value" - should give pause to everyone who thinks the way to solve the intangibles accounting problem is by making sure that everything is included in book value.
Buffett makes clear what he thinks of existing accounting:
Because of our two-pronged approach to business ownership and because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers.
On the other hand, not everyone shares Buffett's investment approach. So efforts to clean up the books will continue.
Posted by Ken Jarboe at March 7, 2005 9:15 AM
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