More Praise for The Warren Buffett Way, First Edition

Washington Post
in 1973, its re-
turn on equity was 15.7 percent. This was an average return for most
newspapers and only slightly better than the Standard & Poor’s Indus-
trial Index. But within f ive years, the Post’s return on equity doubled.
By then, it was twice as high as the S&P Industrials and 50 percent
higher than the average newspaper. Over the next ten years, the Post
Company maintained its supremacy, reaching a high of 36.3 percent re-
turn on equity in 1988.
These above-average returns are more impressive when you observe
that the company has, over time, purposely reduced its debt. In 1973,
long-term debt to shareholder’s equity stood at 37.2 percent, the second
highest ratio in the newspaper group. Astonishingly, by 1978, Katherine
Figure 7.2
The Coca-Cola Company market value.

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I n v e s t i n g G u i d e l i n e s : F i n a n c i a l Te n e t s
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Graham had reduced the company’s debt by 70 percent. In 1983, long-
term debt to equity was a low 2.7 percent—one-tenth the newspaper
group average—yet the Post generated a return on equity 10 percent
higher than these same companies.
“ O W N E R E A R N I N G S ”
Investors, Buffett warns, should be aware that accounting earnings per
share represent the starting point for determining the economic value of
a business, not the ending point. “The first point to understand,” he says,
“is that not all earnings are created equal.”
4
Companies with high assets
to profits, he points out, tend to report ersatz earnings. Because inf lation
extracts a toll on asset-heavy businesses, the earnings of these businesses
take on a miragelike quality. Hence, accounting earnings are useful to the
analyst only if they approximate the expected cash f low of the company.
But even cash f low, Buffett warns, is not a perfect tool for measur-
ing value; often it misleads investors. Cash f low is an appropriate way
to measure businesses that have large investments in the beginning and
smaller outlays later on, such as real estate, gas f ields, and cable com-
panies. On the other hand, companies that require ongoing capital ex-
penditures, such as manufacturers, are not accurately valued using only
cash f low.
A company’s cash f low is customarily defined as net income after
taxes plus depreciation, depletion, amortization, and other noncash
charges. The problem with this definition, Buffett explains, is that it
leaves out a critical economic fact: capital expenditures. How much of
the year’s earnings must the company use for new equipment, plant up-
grades, and other improvements to maintain its economic position and
unit volume? According to Buffett, approximately 95 percent of U.S.
businesses require capital expenditures that are roughly equal to their
depreciation rates. You can defer capital expenditures for a year or so, he
says, but if over a long period, you don’t make the necessary improve-
ments, your business will surely decline. These capital expenditures are
as much an expense to a company as are labor and utility costs.
Popularity of cash-f low numbers heightened during the leveraged
buyout period of the 1980s because the exorbitant prices paid for busi-
nesses were justif ied by a company’s cash f low. Buffett believes that
cash-f low numbers “are frequently used by marketers of business and

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T H E W A R R E N B U F F E T T W AY
securities to justify the unjustif iable and thereby sell what should be un-
salable. When earnings look inadequate to service debt of a junk bond
or justify a foolish stock price, how convenient it becomes to focus on
cash f low.”
5
But you cannot focus on cash f low, Buffett cautions, un-
less you are willing to subtract the necessary capital expenditures.
Instead of cash f low, Buffett prefers to use what he calls “owner
earnings”—a company’s net income plus depreciation, depletion, and
amortization, less the amount of capital expenditures and any addi-
tional working capital that might be needed. It is not a mathematically
precise measure, Buffett admits, for the simple reason that calculating
future capital expenditures often requires rough estimates. Still, quot-
ing Keynes, he says, “I would rather be vaguely right than precisely
wrong.”
Coca-Cola
In 1973, “owner earnings” (net income plus depreciation minus capital
expenditures) were $152 million. By 1980, owner earnings were $262
million, an 8 percent annual compounded growth rate. Then from 1981
through 1988, owner earnings grew from $262 million to $828 million,
a 17.8 percent average annual compounded growth rate (see Figure 7.3).
The growth in owner earnings is ref lected in the share price of
Coca-Cola. In the ten-year period from 1973 to 1982, the total return
of Coca-Cola grew at a 6.3 percent average annual rate. Over the next
ten years, from 1983 to 1992, the total return grew at an average an-
nual rate of 31.1 percent.
P R O F I T M A R G I N S
Like Philip Fisher, Buffett is aware that great businesses make lousy in-
vestments if management cannot convert sales into prof its. In his expe-
rience, managers of high-cost operations tend to f ind ways that
continually add to overhead, whereas managers of low-cost operations
are always f inding ways to cut expenses.
Buffett has little patience for managers who allow costs to esca-
late. Frequently these same managers have to initiate a restructuring
program to bring down costs in line with sales. Each time a company

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I n v e s t i n g G u i d e l i n e s : F i n a n c i a l Te n e t s
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announces a cost-cutting program, he knows this company has not f ig-
ured out what expenses can do to a company’s owners. “The really
good manager,” Buffett says, “does not wake up in the morning and
say, ‘This is the day I’m going to cut costs,’ any more than he wakes up
and decides to practice breathing.”
6
Buffett understands the right size staff for any business operation
and believes that for every dollar of sales there is an appropriate level of
expenses. He has singled out Carl Reichardt and Paul Hazen at Wells
Fargo for their relentless attack on unnecessary expenses. They “abhor
having a bigger head count than is needed,” he says, “and ‘Attack costs
as vigorously when prof its are at record levels as when they are under
pressure.’ ”
7
Buffett himself can be tough when it comes to costs and unnecessary
expenses, and he is very sensitive about Berkshire’s profit margins. Of
course, Berkshire Hathaway is a unique corporation. The corporate staff
at Kiewit Plaza would have diff iculty f ielding a softball team. Berkshire
Hathaway does not have a legal department, a public or investor rela-
tions department. There are no strategic planning departments staffed
with MBA-trained workers plotting mergers and acquisitions. The
company’s aftertax overhead corporate expense runs less than 1 percent
of operating earnings. Compare this, says Buffett, with other companies
Figure 7.3
The Coca-Cola Company net income and “owner earnings.”

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T H E W A R R E N B U F F E T T W AY
that have similar earnings but 10 percent corporate expenses; sharehold-
ers lose 9 percent in the value of their holdings simply because of corpo-
rate overhead.
The Pampered Chef
As mentioned, Doris Christopher founded her company with $3,000
borrowed against her family’s life insurance policy and she never took
on further debt. Today her company has over $700 million in sales.
Customers pay for products before delivery so the company is a cash-
positive business. Alan Luce, president of Luce & Associates in Orlando,
Florida, a direct selling consulting firm, has estimated pretax profit mar-
gins at above 25 percent.
Coca-Cola
In 1980, Coca-Cola’s pretax profit margins were a low 12.9 percent.
Margins had been falling for five straight years and were substantially
below the company’s 1973 margins of 18 percent. In Goizueta’s first
year, pretax margins rose to 13.7 percent; by 1988, when Buffett bought
his Coca-Cola shares, margins had climbed to a record 19 percent.
The Washington Post Company
Six months after the Post Company went public in 1971, Katherine
Graham met with Wall Street security analysts. The first order of busi-
ness, she told them, was to maximize profits from the company’s exist-
ing operations. Profits continued to rise at the television stations and