Saturday, September 09, 2006

Intrinsic Value versus Book Value

Intrinsic value and book value are not the same thing. Intrinsic value is the best measurement when it comes to a decision on investment.

To gain some insight into the differences between intrinsic and book value, an instance will be in the form of investing in a colleage education. Think of the education cost as its "book value". If this cost is to be accurate, it must include the earnings that were foregone by the student because he chose college rather than a job.

For this exercise, we will do away with 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 working, and then subtract from that figure an estimate of what he would have earned had he lacked an education. That will gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to the graduation day. The dollar result equals the economic intrinsic 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 exceeds the book value of the education, 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.

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