Intrinsic value is 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 cash that can be taken out of a business during its remaining life.

Calculating intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and in addition, it is an estimate that must be changed if interest rates move or if forecasts of future cash flows are revised. The following example illustrates my point.

Let’s assume that you are ready to go to college. Think of your college education costs as book value. If this cost is to be accurate, it should include the earnings that were foregone by you because you 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. Let’s further assume that the total of the four-year college tuition expenses is $60,000. After you graduate, you receive a job that yearly pays you a salary in amount of $60,000 (based on your job market research). For the sake of simplicity, we are assuming that this salary will be unchanged for next 30 years. Let’s also assume that since you have chosen education, you have foregone $25,000 worth of earnings for four years. Also, assume had you chosen not to go to the college; you would have earned $30,000 per year for next 30 years (because of lack of education).

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Let’s calculate how much you would earn if you acquire the college education. You should receive a $1.8 million salary for your 30 years of service ($60,000 x 30). Subtract your college education costs of $60,000 and $25,000 (the foregone earnings, since you opted for an education) from this salary; this gives you $1,715,000. From this resultant sum ($1,715,000) subtract your 30-year non-education salary earnings ($900,000 = $30,000 x 30). Thus you will earn in excess of $815,000 ($1,715,000 - $900,000) if you choose a college education. Discounting this with the appropriate interest rate (in our case, a 3% inflation rate) will give us the figure $335,769.

The dollar result ($335,769) equals the intrinsic economic value of the education. Some graduates will find that the book value of their education ($85,000 = $60,000 + $25,000) 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 ($335,769) of an education will far exceed its book value ($85,000 = $60,000 + $25,000). In this case, the result proves that capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.

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