In this entry, I want to cover an all-important business concept. An enterprise is worth what its free cash flows, appropriately discounted, are really going to be; this is my definition of Intrinsic Value.

At first blush, this might seem obvious to some. Or, to others, it might seem wrong.

For example, isn’t a public business worth its “enterprise value”? For those who don’t know, enterprise value can be calculated by summing the the value of debt and equity a public company. Equity value is basically stock prices times the number of shares outstanding. Many people would say an enterprise is worth its “enterprise value”.

University of Chicago, of which I am an alumni, invented the “efficient market theory”, which states that the most accurate estimate of of the value of a public company is it’s enterprise value. Warren Buffett likes to point out that if the efficient market theory was correct, he would more likely be a pan handler than the world’s 2nd richest man. Said differently, enterprise value is sometimes out of sync with intrinsic value.

Berkshire Hathaway has done phenomenally well because it has an incredible record of determining intrinsic value. It invests when it identifies situations where intrinsic value is materially higher than enterprise value.

In the previous blog entry, we discussed how important it is for a company to develop a strong expertise in forecasting cash flows. This skill set ensures that a company is capable of accurately estimating its enterprise value as well as how day to day business decisions either enhance or detract from value. The better a company does at predicting cash flows and in tying cash flows to the true value (true = intrinsic) of their enterprise, the more valuable the enterprise will be.

Warren Buffett has a strong conviction about an executives’ responsibility in communicating intrinsic value to its investors. His opinion might surprise you as it is arguably in contrast to the behavior of most public company CEOs.

Leave a Reply