More Praise for The Warren Buffett Way, First Edition

g
) (add)
5%
Cash flow in year 11
$
3,516
Capitalization rate (
k-g
)4
%
Value at end of year 10
$87,900
Discount factor at end of year 10 (multiply)
0.4224
Pr
esent V
alue of Residual
37,129
Market V
alue of Company
$48,377
Notes:
Assumed first-stage gr
owth rate
=
15.0%; assumed second-stage gr
owth rate
=
5.0%;
k
=
discount rate
=
9.0%.
Dollar amounts ar
e in millions.

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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 7
growth, the present value of the company discounted at 9 percent
would be $38.163 billion. At 10 percent growth for ten years and 5
percent thereafter, the value of Coca-Cola would be $32.497 billion.
And if we assume only 5 percent throughout, the company would still
be worth at least $20.7 billion [$828 million divided by (9
−
5 percent)].
Gillette
Berkshire, as mentioned in Chapter 4, bought $600 million worth of
convertible preferred stock in July 1989. After a 2-for-1 stock split in
February 1991, Berkshire converted its preferred stock and received 12
million common shares, 11 percent of Gillette’s shares outstanding.
Now that Berkshire owned Gillette common yielding 1.7 percent
versus the convertible preferred yielding 8.75 percent, its investment in
Gillette was no longer a f ixed-income security with appreciation po-
tential but a straight equity commitment. If Berkshire were to retain its
common stock, Buffett needed to be convinced that Gillette was a good
investment.
We already know that Buffett understood the company and that the
company’s long-term prospects were favorable. Gillette’s financial char-
acteristics, including return on equity and pretax margins, were improv-
ing. The ability to increase prices thereby boosting return on equity to
above-average rates signaled the company’s growing economic good-
will. CEO Mockler was purposefully reducing Gillette’s long-term debt
and working hard to increase shareholder value.
In short, the company met all the prerequisites for purchase. What
remained for Buffett was to determine the company’s value, to assure
that Gillette was not overpriced.
Gillette’s owner earnings at year-end 1990 were $275 million and
had grown at a 16 percent annual rate since 1987. Although this is too
short a period to fully judge a company’s growth, we can begin to
make certain assumptions. In 1991, Buffett compared Gillette to Coca-
Cola. “Coca-Cola and Gillette are two of the best companies in the
world,” he wrote, “and we expect their earnings to grow at hefty rates
in the years ahead.”
6
In early 1991, the thirty-year U.S. government bond was trading at
an 8.62 percent yield. To be conservative, we can use a 9 percent dis-
count rate to value Gillette. But like Coca-Cola, Gillette’s potential

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1 2 8
T H E W A R R E N B U F F E T T W AY
growth of earnings exceeds the discount rate, so again we must use the
two-stage discount model. If we assume a 15 percent annual growth for
ten years and 5 percent growth thereafter, discounting Gillette’s 1990
owner earnings at 9 percent, the approximate value of Gillette is $16
billion. If we adjust the future growth rate downward to 12 percent,
the value is approximately $12.6 billion; at 10 percent growth, the
value would be $10.8 billion. At a very conservative 7 percent growth
in owner earnings, the value of Gillette is at least $8.5 billion.
The Washington Post Company
In 1973, the total market value for the