The following is an excerpt from ‘The Warren Buffett Way‘, by Robert Hagstrom.
“When Buffett first purchased Coca-Cola in 1988, people asked: “Where is the value of Coke?” The company’s stock price was 15 times earnings and 12 times cash flow – a 30 percent and 50 percent premium to the market average. Buffett paid five times book value for a company with 6.6 percent earnings yield at a time when long-term bonds were yielding 9 percent.
He was willing to do that because of Coke’s extraordinary level of economic good-will. The company was earning 31 percent on equity while employing relatively little in capital investment. Buffett has explained that price tells you nothing about value. The value of Coca-Cola, he said, like that of any other company, is determined by the total owner earnings expected to occur over the life of the business, discounted by the appropriate interest rate.
In 1988, owner earnings of Coca-Cola equaled $828 million. The 30-year U.S. Treasury bond (the risk-free rate) at that time traded near a 9 percent yield. Coca-Cola’s 1988 owner earnings, discounted by 9 percent, would produce an intrinsic value of $9.2 billion. At first glance this seems to suggest that Buffett might have overpaid for the company. But remember that the $9.2 billion represents the discounted value of Coca-Cola’s then-current owner earnings. If buyers were willing to pay a price for Coca-Cola that was 60 percent higher than $9.2 billion, it must have been because they perceived part of the value of Coca-Cola to be its future growth opportunities.
Analyzing Coca-Cola, we find that owner earnings from 1981 through 1988 grew at 17.8 percent annual rate – faster than the risk-free rate of return. When this occurs, analysts use a two-stage discount model. It permits them to calculate future earnings when a company has extraordinary growth for a limited number of years, followed by a period of constant growth at a slower rate.
We can use this two-stage process to calculate the 1988 present value of the company’s future cash flows. In 1988, Coca-Cola’s owner earnings were $828 million. If we assume that Coca-Cola would be able to grow owner earnings at 15 percent per year for the next 10 years (a reasonable assumption, since that rate is lower than the company’s previous seven-year average), by year 10 owner earnings would equal $3.349 billion. Let’s further assume that, starting in year 11, that growth rate will slow to 5 percent per year. Using a discount rate of 9 percent (the long-term bond rate at that time), we can back-calculate the intrinsic value of Coca-Cola in 1988 to be $48.377 billion.
We can repeat this exercise using different growth rate assumptions. If we assume that Coca-Cola can grow owner earnings at 12 percent for 10 years, followed by 5 percent growth, the present value of the company, discounted at 9 percent, would be $38.163 billion. At 10 percent growth for 10 years and 5 percent thereafter, the value would be $32.497 billion. And even if we assume that Coca-Cola could only grow at a steady state of 5 percent throughout, the company would still be worth at least $20.7 billion.”
I find the calculations and valuations found in Hagstrom’s book absolutely fascinating. Now, these figures and formulas are obviously his own interpretation of Buffett’s methods, however I’ve yet to see anything else come close to explaining these methods (save perhaps for Mary Buffett’s ‘Buffettology’). In total, the book covers nine case studies of different businesses Buffett has invested in over the years, and all are illuminating. If you haven’t read it, I highly recommend The Warren Buffett Way.