I didn’t do a good job of explaining it properly; so, let’s look at the “true” profit margin of a company.

The Low Cost Business

We all know that it’s better to have a low-cost business than a high-cost business. Companies with relatively small capital expenditures and fat profit margins should be chosen over those with high capital expenditures and thin margins, assuming all other things are equal.

If you can find good companies that generate tons of cash on a relatively small amount of invested capital, and you can buy those companies at a discount to their intrinsic value, you’ll probably find that your long-term investment results are quite satisfactory.

Profit Margin on One Inventory Turn

So…we turn to two businesses, each of which has a thin profit margin, to see how inventory turns can give us some insight into the economics of the company. Let’s first look at the economics of the business from a single sale perspective to show that they’re the same:

(Note: The number of “inventory turns” refers to the number of times a company must replenish its inventory throughout the year. If Walgreens orders one case of Coca-Cola each month, and sells one case each month, it will have “turned” its Coca-Cola inventory twelve times that year.)

In this case, both businesses earned $2 on $100 of revenue. Their profit margins were 2% ($2 divided by $100). Fortunately, they lived in the land of Tina’s Family Therapy; so, no taxes or any other costs.

Both companies invested $98 in inventory (cost of goods sold), sold it for $100, and made a $2 profit. Simple enough.

Conventional wisdom would say that both businesses should be avoided. We’re supposed to look for businesses with wonderful economics, and a 2% profit margin is anything but “wonderful.” Then again, we’re all about being non-conventional around here.

Profit Margin on Multiple Inventory Turns

Same companies, but factoring one year of inventory turns into the mix:

Right off the bat, these companies may still look similar. Though Company A has greater sales and revenues than Company B, they both boast 2% profit margins and seemingly terrible economics.

Then again, these are businesses, not just numbers on a piece of paper. And the business of Company A is far superior to that of Company B from an owner’s perspective.

What Each Business Invested to Earn Their Income

Let’s first look at Company B. To generate $4 in income, it invested $196 in inventory (cost of goods sold), right? Wrong. Because it had two inventory turns, it invested $98 in inventory to generate $100 in sales, took the profit from that, reinvested the $98 in more inventory, and then turned another sale.

Essentially, Company B invested the same $98 twice to earn $4. Already see where this is going?

Company A invested $98 in inventory to earn $2, but was able to reinvest that $98 eleven more times to generate a total of $24.

Both companies invested $98 to earn $2, but Company A was able to reinvest it faster, thus generating six times more than Company B.

The “true” profit margin of Company A was not 2%, but 24%. The “true” profit margin of Company B was not 2%, but 4%. Here’s how it works:

True Profit Margins…as Bonds

Think of the true profit margin as a bond with a fixed interest rate. Would you rather have a bond paying 24% or a bond paying 4%? The answer is clear.

Company A and Company B both invested $98 into their business through the purchase of inventory. In essence, each purchased a $98 bond (the inventory), and that bond generates a certain amount of profit ($2). Except that Company A’s “bond” pays that $2 monthly while Company B’s “bond” pays $2 every six months.

Which company has better economics? They both have terrible profit margins from an accounting standpoint, but then again – accounting numbers are for the IRS. Business owners and investors follow the cash.

Which Company Will Grow Faster?

It’s pretty clear in the above example that Company A will have a better chance to grow faster than Company B. It generates more in sales, and it generates more cash. Let’s level the playing field. Instead of selling products for $100, Company B is selling higher priced goods. It buys products for $588 and sells them for $600. Both companies have the same revenues, cost of goods, net income, and profit margins:

So…which is the better investment?

Though it looks like we’ve leveled the playing field, we really haven’t. These are two very different businesses. To understand this, we have to work backwards.

How will Company A and Company B generate additional cash? With no other expenses, they each have three choices:

• raise the price of their products (e.g., from $100 to $105, from $600 to $630),
• lower their cost of inventory (e.g., find cheaper inventory at, say, $90 and $500), or
• sell more of their products.

If they can’t raise prices and they can’t find any cheaper suppliers, their only option is to sell more of their product. While that is great in theory, it ain’t so simple in the real world. Unless they have some magic formula for making cash appear out of thin air, how will they purchase additional inventory so that they can sell more of their finished product?

Assuming neither has cash in the bank or access to outside financing, they have one of two choices:

• require payment upfront, and then use the customer’s money to purchase inventory, or
• save up enough cash to purchase more inventory, using the funds of the business.

Some businesses can do the former; but, let’s assume that these two companies are retailers, and that their customers aren’t paying for clothes today, but willing to take delivery in sixty days. To get more inventory which will lead to more sales, the company’s must use the funds of the business.

But wait – neither company has cash in the bank! Okay – how long will it take before the companies can expand? That is…which company will grow faster?

In 4.1 years, Company A will have saved $98 from its $24 of profits – enough to purchase another unit of inventory. With two units of inventory both being sold concurrently, the company is generating twice as much cash.

It will take Company B 24.5 years to save up $588, if saving just $24 per year. As such, Company B will have to wait 24.5 years before it can double its cash flow.

Again – which company has the better economics: the one that can double every four years or the one that doubles every 25?

The Race is Over Before it Begins

If we fast forward and look at these two companies in 25 years, assuming that each tried to beef up their inventory at the end of the year (not 0.1 years into year 4), Company B has finally purchased another unit of inventory and will begin generating $48 a year in excess cash. Company A, on the other hand, has 465 units of inventory and is generating $11,160 in excess cash.

And while Company B has finally beefed up sales to $2,400 ($600 times 2 inventory turns times 2 units of inventory), Company A is generating $558,000 in sales – 233 times the amount of sales!

High Profit Margin/Low Turnover

Finally, consider this: A high profit margin business may have a very low “true” profit margin, and may be a candidate to avoid. When comparing a 2% profit margin business to a 10% profit margin business, many investors automatically assume that the 10% business is better.

That’s not necessarily true.

Everything else being equal, the 10% margin business with one inventory turn is no better or worse than the 2% margin business with five turns a year.

I apologize for any confusion I caused in this post.

Through our investing, we can combat the recession, achieve growth, and keep our heads above water (or fly high). To help us in that endeavor, we must understand the effects of the recession so that we pick the opportunities out of the blood on the streets.

A recession (or worse, a depression) are periods during which the Gross Domestic Product (GDP) of a nation declines for a sustained period (at least two quarters). The formula to calculate GDP is fairly simple:

Let’s take a rational approach to each to see if things will get worse or if we’ve hit the bottom.

Consumer Spending

We know that consumer spending has slowed. We know that it is highly likely to continue slowing, especially as inflation rises and prices get out of control. On CNBC the other night, one interviewee said something to this effect: The consumer may not understand the rate cut entirely, but he sees it as a sign that things are getting better and he’s going to feel better about spending.

Bull.

The reality is that the consumer doesn’t even know the rates were cut. The small minority of us that watch the markets and control our own investing (and have a passion for it) know exactly where the fed rate is and that there have been numerous cuts. Regular Joe American doesn’t give a damn. He’s spending more than he’s saving; his credit card interest rates have not budged (or have risen); prices both at and away from the pump are on the rise; he’s earning spit on his savings account.

Do you think Regular Joe American cares about the rate cut?

The psychological effect of a rate cut (outside of Wall Street) is nothing compared to the psychological effect of the news. Foreclosures. Rising gas prices. Inflation.

My paycheck isn’t cutting it anymore. I really have to tighten my belt. The Fed cut rates again? Great! So why am I paying $4 at the pump? Why can’t I refinance right now? I’m barely keeping my head above water.

From a rational perspective, consumer spending is likely to slow some more. Keep in mind: The doom and gloom in the economy has only been in the news for a few months. As that continues to settle in, consumer spending will likely slow more.

(Not sure? Ask any “regular” person that is not in tune with Wall Street.)

Trade Surplus (Deficit)

When we export more than we import, we add to our GDP. When we import more than we export, we run at a negative. It’s much like personal spending – spend more than you make, and you go into debt. Do it for too long, and you’ll eventually have to downsize. Personally that’s called “bankruptcy”; in the economy, that’s known as a recession.

It’s painfully simple.

Gross Capital Investment

We’re not talking about Regular Joe socking $50 a month into his IRA. Gross Capital Investment is investment in goods that are not consumed, but used for future production. As business investors, we generally understand this as “Capital Expenditures” – investments in plants, property, and equipment that can be used for future production.

The more we import and the less we export, the more we can expect Investment to fall. If consumer spending keeps slowing, there won’t be a need for as much production. (Yes, it’s a slippery slope.) If our exports are strong, Investment can hold up because we can continue to make those Investments and ship the goods overseas.

Government Spending

Government Spending is a combination of Consumer Spending and Investment, only it’s done by the government. If the government is making capital investments or spending money on consumables, that’s generally good for the numbers. Why? In an economy like the US, the government is usually spending that money with US companies that will, in turn, make more Investments and create jobs, thereby increasing wages and allowing Consumer Spending to go up.

(Getting the feeling they’re all tied together? You are absolutely right!)

What’s the solution to a recession?

The solution is well beyond the scope of this discussion; still, you should take away one simple lesson: Get ready to feel some pain.

There is no “one” solution. The stars have to align right – a balance must be made between all of the above. With inflation on the rise (and I expect it to continue for a while, and then stay high for a while), there is money to be made in certain opportunities. Here’s a short list – a starting point:

1. Real estate. It’s a four-letter word right now (which is precisely why you might want to consider looking at it.) As foreclosures continue to rise, people with now-horrendous credit will be looking to rent, and apartment occupancy rates should drop. Building owners that can raise rents to match (or beat) inflation will be able to earn more and more while owing less and less. As I explained to Dan, their cash flows will increase on a real basis while their debts will decrease on both a real and inflation-adjusted bases.
   What’s the move? In the stock market, you may want to look at REITs that focus primarily on residential rental income – preferably ones with strong current and historical balance sheets so there is less likelihood for sub-prime exposure.
2. Basic Needs. Everyone has to brush their teeth, wear deodorant, shave, do laundry, etc. Find the companies that provide basic services to consumers. Apple is nice; still, if the economy turns much worse, expect people to ditch i-Tunes and stop buying i-Phones before they give up personal hygiene. (Of course, we all know that one guy…)
3. Dominance in Basic Wants. When times are tough, you may decide to eat in rather than dining at a Chipotle. But when you need a Coke, you need a Coke. If things get bad, Coke can raise prices to beat inflation. A $15 burrito will drive people away.
4. Parents, Teens, and Tweens. When things take a turn for the worse, parents try to shield this from their kids. Mom may pass on a Coach purse to make sure that junior looks good when he goes out with his friends. If junior is working, he generally has no idea the economy is bad. If he has cash, he’s spending it. Though spending will likely decrease in this area, it will also be one of the first to pick back up.
5. Workouts, and then more workouts. Though workouts can appear at any time, they are most frequent when times are really good and really bad. In the good times, you’ll find a lot of puffy-head management teams trying to make lots of acquisitions because they “should”; in bad times, you’ll find a lot of very smart management teams making acquisitions because they can.

(Note: For 3, 4, and 5 – that’s why Wal-Mart looked so attractive in August of 2007. So long as it is perceived as or remains the place to go for the best price on 3, 4, and 5, it will dominate.)

By now you know that I’m not a bear or a bull, but a realist. I’m not saying we’ve hit the bottom; I’m not saying we haven’t. What I am saying is this: We are presently on a course that will lead us to higher inflation. There will be opportunities along the way, just as there were during and after every recession and depression.

And now you have an idea of where to look.

So…

Mr. Buffett:

Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.

Great businesses will grow regardless of most rational interest rate changes (we can’t do anything if the fed raises them 10% in a day). For example, Buffett bought Coca-Cola in 1988 – when the Federal Funds Rate was rising from 6.5% to 9.75% in that same year. Why?

On a day-to-day basis, most businesses operate regardless of the fed rate – and completely independent of it. Coca-Cola sells Coke by the truck load regardless of the trickle-down effect of the Federal Funds Rate. In addition, it generated gobs of excess cash that allowed it to service virtually any interest rate the banks threw at it.

Of course, Coca-Cola generated so much cash that the banks bent over backwards to throw money at them. (Hint: Look for companies generating tons of cash – companies that can muscle the banks)

But My Stocks Are Down!

Of course your stocks are down. On a day-to-day basis, the markets can do crazy things. Over the long-term, they will increase the prices of valuable companies and lower the prices of bad businesses.

In the short run, the market is a voting machine. In the long run, it’s a weighing machine.

The Business Owner

Back when Gillette was a publicly traded company (it is now a subsidiary of Procter and Gamble), Buffett said:

You go to bed feeling very comfortable just thinking about two and a half billion males with hair growing while you sleep. No one at Gillette has trouble sleeping.

Does a business owner/manager care about the fed rate? For the most part, no. Unless that business is so highly leveraged that its cash flow can barely handle the current debt service, it will be business as usual at the company – with perhaps a smidgen more or less free cash flow at the end of the year.

This Morning At Your Company

What happened this morning at your companies? If you own Blackstone Group (BX), you may not know. Their highly leverages, rate-sensitive investment strategy may be allowing them to profit handsomely from this rate change. Or, they may have gotten crushed overnight as the fed rate moved against them.

I don’t really know. What I do know is that everyone at Coca-Cola likely went to work today to process the day’s orders, handle the invoices, ship cases of Coke, and work to make Coca-Cola more profitable. The fed rate is probably very low on the water cooler “things-to-talk-about” list.

Fed Rates: Noise Or News

If you own great businesses with lots of excess cash flow – businesses that are not sensitive to every blow of the wind – fed rate changes are mostly noise. If, on the other hand, you are gambling in companies with thin cash flows and sensitive business models, the fed rate is news – and the house will usually win.

Ask A Small Business Owner

It is difficult to compare a highly sensitive, highly complex business to that of a small company – but the comparisons are scary when you look at simple, slow-changing businesses vs. small businesses. Simple, slow-changing businesses are easier to value – and as such, it makes sense to compare them to small companies.

Ask a small business owner how the fed rate affected him or her today. More times than not, they’ll look at you funny – as if they didn’t even know the rates have changed and as if the rate change won’t affect the phone calls, sales, and billing they’ll do today.

Those are the businesses you want to own.

The short answer is: The discounted cash flow method always works for valuing a business. But, I’m not known for short answers, so let’s explore the weaknesses in this model. Considering that my spreadsheets have been taken, used, and modified around the web, I think I should qualify a few of the assumptions in there.

Margin Of Error Safety

In order to calculate the intrinsic value of a business, you need to predict, with a degree of certainty, the future owner earnings of that business. You don’t have to be precisely correct, so long as you are not completely wrong. To protect yourself from error, you need to buy at substantial discounts.

Example: If you predict that owner earnings will grow at 14% for ten years, and it only grows at 9%, you should still make money. Why? Margin Of Safety. Johnson & Johnson has a market cap of $193 billion which means the stock market does not believe that Johnson & Johnson’s business is more than that.

At what rate would Johnson & Johnson have to grow in order to be worth $192 billion today? About 4%. Any higher and Johnson & Johnson is underpriced; lower and it is overpriced today.

Predicting The Future With Certainty

In order for your discounted cash flow model to work, you need to be able to reasonably predict the future owner earnings, regardless of the past. That also goes back to my Amylin analysis. I got quite a bit of hate mail from that, but here’s why I don’t like it for me-or for most investors:

At this point, it is nearly impossible to predict the future owner earnings of that (or any) business that has never generated any. There is, in my opinion, no way to know how Amylin will turn revenues into cash for us silent partners. Because of that, there is no way to know if Amylin is, in fact, a $6 billion company.

For any discounted cash flow model to work, you need to have solid reasoning and data. Simple, predictable, established businesses offer that; the “next hot stock” usually doesn’t.

The Discount Rate and What It Means

Your discount rate affects everything-from your margin of safety to your future expectations. Buffett has said:

Don’t use different discount rates for different businesses…it doesn’t really matter what rate you use as long as you are being intellectually honest and conservative about future cash flows.

If you are using a 15% discount rate, understand that you’ll end up with lower valuations and will need to accept a smaller margin of safety (25% vs. 50%). Why? Look at the Coca-Cola example from 1988. At that time, with a 15% discount rate, Coca-Cola was valued at $59 a share. Had Buffett tried to use a 15% discount rate and a 50% margin of safety, he would have never bought Coca-Cola because it never hit $29.50 a share in 1988 or 1989.

Using a lower rate-8.85%, the 10-Yr. treasury-Coca-Cola’s value in 1988 would have been closer to $91 a share. With a 50% Margin of Safety, Coca-Cola was attractive at Buffett’s purchase price around and under $45 a share.

Consistency

It may not always be practical to assume that the future owner earnings will grow at exactly one rate for ten years, then exactly another rate for the next ten. As I’ve said before, there is an art to investing…not just the science of the spreadsheet.

You don’t have to predict the future with bulls eye precision; still, some businesses will certainly not be able to grow consistently for ten years before they level off. Some companies may only have five years left before growth slows; some may go on for much longer than ten years.

If you’re not sure how long the business has left, pass. You can make gobs of money in simple, giant companies.

You Don’t Need High Risk For High Returns

It is in our nature to look (or hope) for the next undiscovered Microsoft, but we don’t need to. You can make gobs of money in slow-growing, boring businesses. It all depends on your purchase price and how long it takes for the stock market to bring the price up to the business’ intrinsic value.

If a business is valued at $100 a share but its stock is $50 a share, here’s how your money would grow based on a 5% growth in the business and the time it took for the market to finally price the business back to its intrinsic value:

Once the difference between price and value gets too wide (beyond 25% to 50%), it often takes two or three years for that gap to close again. Still, if it took seven years, you probably wouldn’t be too upset with a 16% average annual return and little risk.

There Is More Than One Way To Skin A Business

Next week I’ll compare a few different methods for valuing businesses. Which is the best? As you’ll see, some will make absolutely no sense except that they’ve been backtested well, some can be used for trading stocks, and some will bring you to exactly the same conclusions as F Wall Street.

In the end, it all depends on what you want out of your portfolio. Me? I like high returns with low risk, little excitement, and low maintenance. I’m not much of a gambler…except in Vegas.

So, quick, to answer your question: Is your business predictable, consistent, and sporting a moat and large margin of safety? Do you want to find the value, ignore the markets, and wait for the price to catch up to the intrinsic value? If yes, yes, yes, yes, etc, then you can use the discounted cash flow model on TGT.

Buffett is noted for saying,

You can’t compensate for risk by using a high discount rate.

Does that mean we shouldn’t use a high rate? Does it mean that using a high rate is risky?

How the discount rate affects calculations

The higher the discount rate, the lower the valuation…and vice versa. But valuing businesses is not just about the discount rate-you need a margin of safety. The two go hand in hand.

Discount rate and margin of safety

If you use a higher discount rate, you’ll end up with a lower valuation. When that happens, you can buy great companies with a lower margin of safety than if you use a low discount rate.

Let’s look at the valuations. For this example, we’ll use the Coca-Cola valuation in 1996:

• At 15%: We estimated Coca-Cola’s value at $30.45 per share. Because it is an industry leader, I said we could comfortably buy it at a 25% discount, or $22.84 a share. The total valuation for the company came in at $75.8 billion.
• At 9%: If we were to discount the future cash at 9%, Coca-Cola’s value would have come in at $125 billion, or $50.25 per share. But if we’re using 9%, we should have a 50% margin of safety (I’ll explain in a second) giving us a target buy price of $25.13 per share.

Why change the margin of safety?

Hey, I’m not making this stuff up-I analyzed Buffett’s past purchases and found that:

• at a 15% discount rate, he was buying at a 25% margin of safety for big companies.
• using a 9% discount rate (8.85% for Coca-Cola in 1988), he had a 50% margin of safety.

Why did I use 8.85%? That was the rate that the ten-year, risk-free US bond was offering in 1988. Why did I use 15%? That is the minimum return I expect when I buy a stock.

The results are close enough in this inexact science

Either way, the purchase prices, with their respective margins of safety, are so close together that the result ends up roughly the same.

So, what was Buffett saying?

I believe that Buffett was saying that a risky company is a risky investment, no matter how you justify the purchase. Using a 15% (or higher) discount rate means you end up with a lower overall valuation and purchase price. But in the end, a bad business is a bad investment no matter how cheaply you bought it.

To demystify and paraphrase a bit, Joe Ponzio says (if you really care, that is):

Bad companies are bad investments, no matter what price you pay for them. The more time you spend rationalizing your purchase, the less money you should put into it.

So, what rate should I use?

Whatever rate you want, so long as you factor in an appropriate margin of safety to compensate for your (our) inability to predict the future. The lower the discount rate, the wider the margin of safety. Discount rates aren’t about risk…they’re about valuing businesses.

Personally, I use 15% and require a 25% margin of safety on large, stable companies and a 50% margin of safety on less-than-sure companies. For additional details and justification, take a look at Michael’s question and my response on the Johnson & Johnson valuation.

In 1988, Wall Street said Coca-Cola was a bad stock to buy. Warren Buffett thought it was a wonderful business to own. The results speak for themselves; so, let’s look at the reasoning behind Warren Buffett’s most famous purchase.

You can follow along by downloading the PDF version of the analysis here. (Yes, it’s free.)

The Cash Cow

From 1978 through 1987, Coca-Cola’s Free Cash Flow grew at a median rate of 21.8% a year. Buffett himself says we should not take yearly results too seriously, so we focus on multi-year results. Then again, Coca-Cola’s Free Cash Flow grew fairly steadily each year-a definite plus!

The Net Worth

Coca-Cola’s Shareholder Equity had been growing about 7.8% a year. Not stellar by any means, but it was consistent and predictable-both staples in the Buffett approach to investing. The growth rate of Shareholder Equity becomes critically important only when you expect your company to close up shop in the next twenty years-clearly not in the stars for Coca-Cola.

Management And Money

Coca-Cola had a median CROIC of 9.3% for ten years. For every dollar of capital invested in the company, Coca-Cola was generating $0.09 of cash. As I mentioned in this discussion of CROIC, I prefer to see CROIC above 13%. Any lower and the numbers become fragile. Then again, Coca-Cola was a special situation because of its brand and moat. In 1988, Coca-Cola was anything but fragile.

Brand And Moat

A company that needs no introduction, Coca-Cola was the company in the beverage industry…and in the world. It dominated the market and had no serious competition. Picture a world where there was practically no Pepsi, Snapple, or bottled water on the shelves-just Coke. That is pretty much 1988.

In 1988, you would have been hard pressed to find a more well-known name than Coca-Cola. Now that is moat.

The Valuation

Assuming the company could continue to grow Free Cash Flow at 21.8% a year for ten years, and then slowed to 5% thereafter, and assuming Buffett wanted a 15% or more average annual return, you could value Coca-Cola at $22.3 billion, or $59.16 a share in 1988.

For new readers: The $22.3 billion is made up of $2.09 billion of Shareholder Equity and the net present value of the estimated $98.89 billion of future cash flow, discounted at 15% for a handsome return. Here is why we look at these numbers. See Calculating The Value Of A Business for a more detailed explanation of the calculation.

The Purchase

Of course, you shouldn’t pay full price for a company-even one as solid as Coca-Cola. If the future is a little less rosy than you projected, your returns head south. So, you need a discount. Being an industry leader (the industry leader), Coca-Cola could have been purchased with as little as a 25% Margin Of Safety (discount).

At a 25% discount to value, Coca-Cola could have been purchased at any time at or below $44.37. In 1988, the company’s stock traded between $35 and $45.25, giving Buffett a discount between 24% and 41%.

The Result

Today, Buffett’s stock in Coca-Cola is worth more than $10 billion, and he collects more than $270 million a year in dividends. Not bad, considering how easy it was to find the value in this “no-brainer” investment.

What Wall Street Said

Wall Street thought Buffett was nuts. In 1987, earnings were down nearly 2% from their 1986 peak-surely not the sign of a growing company! With a price-to-earnings (PE) ratio of 14 to 19, the company seemed fairly valued at best, if not overvalued.

And once again, Buffett showed the world why Wall Street’s earnings mean nothing to the business investor, how to invest like a business owner, and why you are right when your data and reasoning are right-not because the crowd agrees or disagrees.

A quick thanks to Chris at MSU for finding the annual reports and making my job easy!

If you are blindly speculating in stocks or putting money into Wall Street’s mutual funds, reinvesting your dividends may very well be the only thing that saves your portfolio. But, if you are buying wonderful businesses at a discount, reinvesting suddenly becomes silly. After all, Warren Buffett doesn’t do it. He’s pretty smart, right?

A Quick Look At His Holdings

Berkshire Hathaway owns or controls 200 million shares of Coca-Cola (ticker: KO). Its position is the same as it was in 1999. With KO’s dividend at $1.36 a share, Buffett is collecting $272 million a year in dividends. But…he’s not reinvesting them.

Wall Street Says…

If Buffett were reinvesting his dividends, he’d increase his position in KO by another 2% or so each year. Following that advice since his initial purchase in 1988, Buffett’s stake in Coca-Cola would be much larger today.

That’s Not What He’s About

Buffett isn’t interested in owning large stakes in businesses-he is interested in creating wealth for his shareholders. Owning large pieces of businesses comes with the job.

Considering that Buffett’s primary goal is growth, he would silly to reinvest his dividends (and he doesn’t). Though a gambler can get short-term growth anywhere, to get growth as an investor you have to buy businesses when they are on sale. When they are not on sale, you have to find value elsewhere-even if that means sitting in cash.

Once Coca-Cola began trading at a price that was no longer “fair” to Mr. Buffett, he stopped buying it. Buying Coca-Cola at a discount was brilliant. Investing that $272 million in dividends in a company that is overpriced is, well, the opposite. Why overpay for value and guarantee a poor return when you can simply be patient until you find the next Coca-Cola?

What Are You About?

When it comes to your money, are you one who buys businesses at a discount and refuses to overpay-even in “dividend-size” increments? Or, do you follow Wall Street into the market and secretly hope that your reinvested dividends make up for Wall Street’s mistakes?

First, let’s take a look at the value of Coca-Cola’s business at the end of 1996. You can follow along by looking at the 1996 spreadsheet:

From 1987 though 1996, KO grew Free Cash Flow a median rate of 16.2%. Stellar. In addition, it generated roughly $0.42 of cash for every dollar of invested capital. Even better! Shareholder equity was growing at about 8% which isn’t that great. Still, we can put a value on the company.

Getting Coca-Cola’s 1996 Value

Shareholder equity plus our estimation of the future Free Cash Flow gives us a value of $75,752 million. Divide that by the number of outstanding shares at the end of 1996 gives us a per-share value of $30.42. But Coca-Cola never hit $30.42, let alone our target price of $22.84 when factoring in a 25% margin of safety. In 1997, Coca-Cola’s stock traded between $50 and $72.62, well above the value of the company.

One of three things had to happen:

1. Coca-Cola’s value would rise quickly to justify the high price; or,
2. The price would have to hold steady until Coca-Cola’s value crept up to it; or,
3. The price would have to drop to a level more consistent with Coca-Cola’s value.

On a daily and monthly basis, price can do anything. Over the long-term, price follows value.

What to Do With Coca-Cola In 1996

The goal of long-term investing is to buy a wonderful company at a fair or bargain price. In the case of Coca-Cola, investors were buying a business at a high price-well more than the company was worth if an investor wanted to earn 15% or more on an annualized basis.

The long and short of it is simple: You can’t overpay for a business, and then be surprised when you lose money (or don’t make a lot). In the case of KO, you could have speculated on its stock price and made some money, but you could not have reasonably expected to be a long-term, stellar-return holder of KO’s stock when buying it in 1996.

Fast Forward to 2007

As it turns out, Situation Two (above) occurred-the stock price moved up and down greatly from month to month, but the long-term price held fairly level at the 1996 price. You can see a chart of its price movement (using end-of-day prices). The red dashed line connects the 1996 price to the end of 2006 price.

What about Coca-Cola’s value? Here’s the 2006 analysis.

The value hasn’t changed much-from $30.45 a share at the end of 1996 to $30.85 a share at the end of 2006. Price follows value, so it is no surprise to see that Coca-Cola’s price, on a long-term basis, barely moved an inch.

But Coca-Cola Grew!

Yes, Coca-Cola’s net worth grew by more than $10 billion. If you bought KO in 1996 and it shut down in 2006, you would be entitled to your fair share of that extra $10 billion. But Coca-Cola isn’t shutting down and the value of the company is not simply its net worth.

Coca-Cola has a value as an ongoing business-its intrinsic value. Though its “break-up” value grew from 1996 through 2006, its intrinsic value, and hence its value, as an ongoing business stayed fairly flat.

Did Mr. Buffett Screw Up With Coca-Cola?

Warren Buffett bought Coca-Cola in 1988, back when the company was growing rapidly. If our valuation methods are similar, he likely projected ten years of great growth from 1989-1998, followed by ten years of slowed growth.

During the first ten years, Coca-Cola’s free cash flow grew roughly 12.7% a year and its shareholder equity grew 9.9% a year. With Mr. Buffett’s margin of safety, his investment grew much more rapidly.

Remember that Warren Buffett bought Coca-Cola back in 1988 when it was a very attractive company selling at a fair price. That was nearly 20 years ago. Today, Coca-Cola is not as attractive and not selling at a fair price. Does Buffett care? Sure, he’d love to see all of his companies growing rapidly forever.

Will he sell? Probably not. He likely paid for 20 years’ worth of growth. Anything beyond that simply adds to his wealth. So long as Coca-Cola is growing, no matter how quickly or slowly, he probably won’t be going anywhere.

So no, he didn’t screw up.

What It All Adds Up To

At any given time, you could have made a little or a lot of money by speculating in Coca-Cola’s stock from 1997 through 2006. Traders and gamblers pushed the stock as high as $88.94 and as low as $37.01 during that time. The ones who got hurt were the long-term investors (and the gamblers on the wrong side of the trades).

A look at the business of Coca-Cola could have saved you ten years’ worth of ups, downs, and ultimately a flat return. Remember, buying stock is buying a piece of a business. If you don’t know the value of your business, you are simply gambling.