More Praise for The Warren Buffett Way, First Edition

The Theor y of Investment Value,
as the best way to determine the value of a security.
Paraphrasing Williams, Buffett tells us that the value of a business is
the total of the net cash f lows (owner earnings) expected to occur over
the life of the business, discounted by an appropriate interest rate. He
considers it simply the most appropriate yardstick with which to mea-
sure a basket of different investment types: government bonds, corpo-
rate bonds, common stocks, apartment buildings, oil wells, and farms.
The mathematical exercise, Buffett tells us, is similar to valuing a
bond. The bond market each day adds up the future coupons of a
bond and discounts those coupons at the prevailing interest rate; that
determines the value of the bond. To determine the value of a busi-
ness, the investor estimates the “coupons” that the business will gener-
ate for a period into the future and then discounts all these coupons
back to the present. “So valued,” Buffett says, “all businesses, from

---

I n v e s t i n g G u i d e l i n e s : V a l u e Te n e t s
1 2 3
manufacturers of buggy whips to operators of cellular telephones, be-
come economic equals.”
2
To summarize, then, calculating the current value of a business
means, f irst, estimating the total earnings that will likely occur over the
life of the business; and then discounting that total backward to today.
( Keep in mind that for “earnings” Buffett uses owner earnings—net
cash f low adjusted for capital expenditures, as described in Chapter 7.)
To estimate the total future earnings, we would apply all we had
learned about the company’s business characteristics, its f inancial
health, and the quality of its managers, using the analysis principles de-
scribed thus far. For the second part of the formula, we need only de-
cide what the discount rate should be—more on that in a moment.
Buffett is f irm on one point: He looks for companies whose future
earnings are as predictable, as certain, as the earnings of bonds. If the
company has operated with consistent earnings power 
and
if the busi-
ness is simple and understandable, Buffett believes he can determine its
future earnings with a high degree of certainty. If he is unable to proj-
ect with conf idence what the future cash f lows of a business will be, he
will not attempt to value the company. He’ll simply pass.
This is the distinction of Buffett’s approach. Although he admits
that Microsoft is a dynamic company and he regards Bill Gates highly
as a manager, Buffett confesses he hasn’t a clue how to estimate the fu-
ture cash earnings of this company. This is what he means by “the cir-
cle of competence”; he does not know the technology industry well
To properly value a business, you should ideally take all the
f lows of money that will be distributed between now and judg-
ment day and discount them at an appropriate discount rate.
That’s what valuing businesses is all about. Part of the equation
is how confident you can be about those cash f lows occurring.
Some businesses are easier to predict than others. We try to
look at businesses that are predictable.
3
W
ARREN
B
UFFETT
, 1988

---

1 2 4
T H E W A R R E N B U F F E T T W AY
enough to project the long-term earnings potential of any company
within it.
This brings us to the second element in the formula: What is the
appropriate discount rate? Buffett’s answer is simple: the rate that
would be considered risk-free. For many years, he used the rate then
current for long-term government bonds. Because the certainty that the
U.S. government will pay its coupon over the next thirty years is virtu-
ally 100 percent, we can say that this is a risk-free rate.
When interest rates are low, Buffett adjusts the discount rate up-
ward. When bond yields dipped below 7 percent, Buffett upped his dis-
count rate to 10 percent, and that is what he commonly uses today. If
interest rates work themselves higher over time, he has successfully
matched his discount rate to the long-term rate. If they do not, he has
increased his margin of safety by three additional points.
Some academicians argue that no company, regardless of its
strengths, can assure future cash earnings with the same certainty as a
bond. Therefore, they insist, a more appropriate discount factor would be
the risk-free rate of return 
plus
an equity risk premium, added to ref lect
the uncertainty of the company’s future cash f lows. Buffett does not add
a risk premium. Instead, he relies on his single-minded focus on com-
panies with consistent and predictable earnings and on the margin of
safety that comes from buying at a substantial discount in the first place.
“I put a heavy weight on certainty,” Buffett says. “If you do that, the
whole idea of a risk factor doesn’t make any sense to me.”
4
Coca-Cola
When Buffett f irst purchased Coca-Cola in 1988, people asked:
“Where is the value in Coke?” Why was Buffett willing to pay f ive
times book value for a company with a 6.6 percent earning yield? Be-
cause, as he continuously reminds us, price tells us nothing about value,
and he believed Coca-Cola was a good value.
To begin with, the company was earning 31 percent return on eq-
uity while employing relatively little in capital investment. More im-
portant, Buffett could see the difference that Roberto Goizueta’s
management was making. Because Goizueta was selling off the poor-
performing businesses and reinvesting the proceeds back into the
higher-performing syrup business, Buffett knew the f inancial returns

---

I n v e s t i n g G u i d e l i n e s : V a l u e Te n e t s
1 2 5
of Coca-Cola were going to improve. In addition, Goizueta was buying
back shares of Coca-Cola in the market, thereby increasing the eco-
nomic value of the business even more. All this went into Buffett’s
value calculation. Let’s walk through the calculation with him.
In 1988, owner earnings of Coca-Cola equaled $828 million. The
thirty-year U.S. Treasury Bond (the risk-free rate) at that time traded
near a 9 percent yield. So Coca-Cola’s 1988 owner earnings, discounted
by 9 percent, would produce an intrinsic value of $9.2 billion. When
Buffett purchased Coca-Cola, the market value was $14.8 billion, 60
percent higher, which led some observers to think he had overpaid. But
$9.2 billion represents the discounted value of Coca-Cola’s then-
current owner earnings. If Buffett was willing to pay the higher price,
it had to be because he perceived that part of the value of Coca-Cola
was its future growth opportunities.
When a company is able to grow owner earnings without addi-
tional capital, it is appropriate to discount owner earnings by the differ-
ence between the risk-free rate of return and the expected growth of
owner earnings. Analyzing Coca-Cola, we f ind that owner earnings
from 1981 through 1988 grew at a 17.8 percent annual rate—faster
than the risk-free rate of return. When this occurs, analysts use a two-
stage discount model. This model is a way of calculating future earnings
when a company has extraordinary growth for a certain number of
years and then 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 f lows (see Table 8.1). First, assume
that starting in 1988, Coca-Cola would be able to grow owner earnings
at 15 percent per year for ten years. This is a reasonable assumption,
since that rate is lower than the company’s previous seven-year average.
By the tenth year, the $828 million owner earnings that we started
with would have increased to $3.349 billion. Let’s further assume that
starting in the eleventh year, growth rate will slow to 5 percent a year.
Using a discount rate of 9 percent (the long-term bond rate at the
time), we can back-calculate the intrinsic value of Coca-Cola in 1988:
$48.377 billion (see Notes section at the end of this book for details of
this calculation).
5
But what happens if we decide to be more conservative, and use
different growth rate assumptions? If we assume that Coca-Cola can
grow owner earnings at 12 percent for ten years followed by 5 percent

---

1 2 6
Table 8.1
The Coca-Cola Company Discounted Owner Ear
nings Using a T
wo-Stage “Dividend” Discount Model (first stage is ten years)
Ye
ar
123456789
10
Prior year cash flow
$828
$0,952
$
1,095
$1,259
$
1,448
$1,665
$1,915
$2,202
$2,532
$2,912
Gr
owth rate (add)
15%
15%
15%
15%
15%
15%
15%
15%
15%
15%
Cash flow
$952
$1,095
$
1,259
$1,448
$
1,665
$1,915
$2,202
$2,532
$2,912
$3,349
Discount factor (multiply)
0.9174
0.8417
0.7722
0.7084
0.6499
0.5963
0.5470
0.5019
0.4604
0.4224
Discounted value per annum
$873
$
922
$
972
$1,026
$
1,082
$1,142
$1,204
$1,271
$1,341
$1,415
Sum of pr
esent value of cash flows
$11,248
Residual V
alue
Cash flow in year 10
$
3,349
Gr
owth rate (