Understanding the intrinsic value of assets

The legendary investor Warren Buffett, while explaining how to arrive at the intrinsic value of an asset, told his audience at an annual meeting of his company in 2007: “Let's say you decide you want to buy a farm and you make calculations that you can make $70 per acre as the owner. How much will you pay [per acre for that farm]? Do you assume agriculture will get better so you can increase yields? Do you assume prices will go up? You might decide you wanted a 7 per cent return, so you'd pay $1,000/acre. If it's for sale at $800, you buy, but if it's at $1,200, you don't.”

Buffet also offers the simplest definition of intrinsic value, thus: “Discounted value of the cash that can be taken out of a business during its remaining life”. This definition itself gives rise to two difficult set of questions. One, how does one estimate how much cash the business will generate in its remaining lifetime? Second, how does one decide on the rate at which the cash value is to be discounted?

To arrive at the intrinsic value, one can calculate the opportunity cost of investing in that asset vis-a-vis investing in an alternative asset. If the asset scores high on the opportunity cost, that is, if the returns from the asset are expected to higher than the alternative asset, then it makes sense to buy it. However, if it score is lower, then the alternative asset would be a better option for investment.

As for the discounted cash flow (DCF) of the business, it is difficult to estimate the rate at which the company will grow in future. A fast-paced growth rate in the past does not guarantee that the company will continue to grow at the same rate in future, so estimating the discounted value of the future cash flow can only be termed as a speculative activity. Hence, estimating the intrinsic value of an asset is a difficult exercise, notwithstanding the claims of number-crunching analysts and financial wizards.