Warren Buffett (Trades, Portfolio) has a second name for what he called “wonderful companies at a fair price.” That name is “equity bonds” and was explained in Mary Buffett and David Clark’s book, “Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage.”
The authors said the reason he used that name is because companies with durable competitive advantages, or moats, resemble bonds in the sense that they can be counted on to deliver consistent returns year after year. Even better, rather than receiving a flat “coupon” rate, these companies can be expected to increase their pretax earnings each year. There may be dividends, which would be a bonus, but pretax earnings are the important drivers.
They wrote:
“What attracts Warren to the conceptual conversion of a company’s shares into equity/bonds is that the durable competitive advantage of the business creates underlying economics that are so strong they cause a continuing increase in the company’s earnings. With this increase in earnings comes an eventual increase in the price of the company’s shares as the stock market acknowledges the increase in the underlying value of the company.”
They gave several examples, beginning with one of Buffett’s great acquisitions: shares of Coca-Cola Co. (KO, Financial). He began buying them in the late 1980s at an average price of $6.50 per share, when the shares were generating 70 cents in pretax earnings (46 cents after tax). This was also at a time when its earnings were growing roughly 15% per year.
With these facts in mind, Buffett could say he and Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) were buying a Coca-Cola equity bond paying an initial pretax interest rate of 10.7% (0.70 / $6.50). The authors added, “What he is saying is that at $6.50 a share, he was being offered a relatively risk-free initial pretax rate of return of 10.7%, which he expected to increase over the next 20 years at an annual rate of approximately 15%. Then he asked himself if that was an attractive investment given the rate of risk and return on other investments.”
By 2007, pretax earnings had risen to $3.96 per share ($2.57 after tax). That’s earnings of $3.96 on a cost base of $6.50 per share, or a yield of 60% pretax (40% after tax).
The authors then contrasted these results with those who follow Benjamin Graham’s traditional approach:
“To the Graham-based value investors, a pretax 10.7% rate of return growing at 15% a year would not be interesting since they are only interested in the stock’s market price and, regardless of what happens to the business, have no intention of holding the investment for more than a couple of years. But to Warren, who plans on owning the equity bond for 20 or more years, it is his dream investment.”
Another example: The Washington Post Co., which is now a subsidiary of Graham Holdings Co. (GHC, Financial). He made his initial investment at an average price of $6.36 per share in 1973. By 2007, 34 years later, the company was generating pretax earnings of $34 per share. That worked out to a pretax yield of 849% (534% after tax). In that same year, shares were trading between $726 and $885 each.
Another couple of examples (as of 2007):
- American Express (AXP, Financial): pretax yield of 38%.
- Proctor & Gamble (PG, Financial): 49%.
- See’s Candy: 328%.
Authors Buffett and Clark explained that the stock market eventually matches stock prices with underlying values because the earnings are so consistent.
This situation also can make a company a target for a leveraged buyout. When a company has little or no debt and a record of strong earnings, it may become a target if its price reaches a low level. Once in control, the new owners can finance the purchase with the earnings available to them. Interest rates are also a factor because lower interest rates make a company’s earnings worth more as they can handle more debt. In the same manner, higher interest rates support less debt and, as a result, the company’s stock becomes less valuable.
Now, to the valuation model: What would be the discounted value of a Coca-Cola share worth $6.50 in 1987? Here’s how the authors laid out the analysis:
- They use a discount rate of 7%; “which is right about what long-term rates were back then.”
- That produces a “discounted back value” of about 17%.
- Multiply that 17% by $6.50 to get projected earnings of $1.10.
- Multiply $1.10 by 14, which was Coca-Cola’s 1987 price-earnings ratio.
- The result is a valuation of $15.40.
From Buffett’s perspective, he was buying an equity bond for $6.50, an equity bond that had an intrinsic value of $15.40. By 2007, 20 years later, Coca-Cola was trading between $45 and $64 per share and had pretax earnings of $3.96 per share.
In Buffett’s case, the returns were even sweeter because he did not sell his stock and incur taxes. As the authors wrote in 2008:
“Consider this: Warren has approximately $64 billion in capital gains on his Berkshire stock and has yet to pay a penny in taxes on it. The greatest accumulation of private wealth in the history of the world and not a penny paid to the taxman.
Does it get any better?”
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Buffett on Financial Statements: The Cash Flow Statement
- Buffett on Financial Statements: Balance Sheet, Shareholders' Equity
- Buffett on Financial Statements: Balance Sheet Liabilities
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