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  • Novalis_97 Novalis_97 Aug 14, 1998 10:12 PM Flag

    KO's price about where it should be

    Buffett calculates the intrinsic value of a stock
    the same way he calculates the intrinsic value of a
    type of bond called a perpetuity. He believes there is
    a select group of companies in the world (like Coke
    and Gillette) whose cash flows are as reliable and
    predictable as the coupons on a perpetuity bond. Thus,
    Buffett uses the perpetuity formula to determine the
    intrinsic value of such companies.

    The formula for a
    perpetuity is C / (r - g), where --

    C is "owner
    earnings (net income + depreciation + amortization -
    capital expenditures),"

    r is the discount rate
    (historic 30-yr bond rate), and

    g is the growth rate
    of the owner earnings (if any).

    (It's
    important to note that the formula calculates the intrinsic
    value one year PRIOR TO the beginning of the cash flow.
    To compute the intrinsic value at the time of the
    cash flow, multiply the IV by whatever g
    is.)

    Coke's year-end 1997 intrinsic value = [(net income +
    depreciation + amortization - capital expenditures) /
    (historic 30-yr bond yield - owner earnings' growth rate)]
    * (1 + owner earnings' growth rate)

    So
    year-end 1997 IV = [($4,129 mil. + $384 mil. + $242 mil. -
    $1,093 mil.) / (0.10 - 0.08)] * (1.08)

    = $197,748
    mil. (Coke's year-end 1997 INTRINSIC MARKET
    CAP)

    Divide $197,748 mil. by the number of Coke shares
    outstanding as of 12/31/97, 2,470.718 million, to get a
    per-share intrinsic value figure of $80 (I said $81 before
    but I'm correcting myself).

    Coke's actual
    year-end 1997 market cap was $164,766 mil., which
    represents a margin-of-safety of 17% vis-a-vis its intrinsic
    market cap at the time of $197,748 mil. Coke was
    undervalued by 17% at the end of 1997.

    Now if you do
    the above in Excel for each of the past 10 years, you
    will see that Coke's intrinsic value, because its
    business is growing, has actually led, rather than lagged,
    Coke's market value. A lot of people wonder how Coke's
    market price can go up every year as it has. The answer
    is because Coke is a very strong company whose owner
    earnings are growing every year and constantly raising
    Coke's business value.

    *********

    Buffett
    defined "owner earnings" in Berkshire's 1986 Annual
    Report.

    Buffett indicated 10% as the discount rate he uses in his
    1991 Letter to Shareholders (see section labeled "Some
    Valuation Math").

    A growth rate of 8% is reasonable.
    In his 1991 letter, Buffett identified the growth
    rate to use for media franchises as 6%, and since Coke
    is a better franchise in Buffett's view than the
    Washington Post, it's only reasonable to assume Coke's
    growth rate is higher. Incidentally, Buffett mentioned
    in his 1991 Letter that all media companies' growth
    rate would decrease dramatically in the future and,
    consequently, so would their intrinsic values.

    SortNewest  |  Oldest  |  Most Replied Expand all replies
    • I've told you before that your formula for
      valuing stocks is wrong. Let's see, you calculate a value
      of $80 using a 10% discount rate and an 8% owner
      earnings growth rate.

      So what is the value if you
      use a 15% owner earnings growth rate? Intrinsic value
      should be higher if they grow faster, right?
      Unfortunately, using that k - g formula (.10 - .15), you get a
      negative value.

      Why would you persist in using a
      formula that clearly makes no sense for the application?

      • 2 Replies to Beethoven_57
      • It is Saturday night and here you are on the KO board (me too.) What are we, old and married? Oh well, next week ought to be nothing less than interesting. Have a great weekend.

        Kingfisher

      • Remember what a perpetuity is -- it's a bond
        whose coupons are paid out FOREVER. No company can keep
        its owner earnings (its "coupons") growing at 15%
        forever. They can do it for a number of years, but
        eventually it will fall below 10%. That is why you can use
        the formula. If you found a company that indeed could
        grow its owner earnings at 15% FOREVER, it would in
        fact be worth infinite dollars.

        You use a
        two-stage dividend discount model for companies whose owner
        earnings currently and temporarily exceed the risk-free
        rate (10%). Then when the owner earnings fall to a
        constant level below 10%, you apply the perpetuity
        formula. Alternatively, you can make the conservative
        assumption that owner earnings currently do not exceed 10%
        at all but are presently growing at the rate at
        which you expect them to grow forever (8% for Coke).
        Then you don't have to use the two-stage dividend
        discount model at all -- but you can immediately apply the
        perpetuity formula.

        Buffett calls Coke the greatest
        company in the world. While its owner earnings are
        currently growing about 20% a year, not even Buffett
        assumes Coke will grow at this rate FOREVER. 8% is a
        reasonable "forever" rate. Why? Because in Buffett's 1991
        Shareholder Letter, he used 6% as the Washington Post's
        "forever" growth rate, but Buffett considers Coke to be a
        better franchise than the Washington Post so I assume 8%
        is reasonable. By the way, Buffett also uses 10% as
        his discount rate in this intrinsic value calculation
        example, and I suggest you look at the 1991 Letter
        (http://www.berkshirehathaway.com/letters/1991.html) to convince yourself that Buffett indeed uses the
        perpetuity ("perpetual annuity") formula to compute
        intrinsic value (look under the section entitled, "Some
        Valuation Math"). To understand what Buffett's talking
        about better, I'll do the math for you:

        When
        newspaper's growth rate = 6%:

        PV = C / (r - g) = $1
        mil. / (0.10 - 0.06) = $1 mil. / 0.04 = $1 mil. /
        (1/25) = $1 mil. * 25 = $25 mil.

        When newspaper's
        growth rate has decreased to 6%:

        PV = C / (r - g)
        = $1 mil. / (0.10 - 0.00) = $1 mil. / 0.10 = $1
        mil. / (1/10) = $1 mil. * 10 = $10 mil.

    • I here-by induct you into the society of ex farmer red necks of
      Americia. The higest honor the Sgt at Arms can bestow.
      notbuffett

      • 1 Reply to notbuffett
      • Novalis did have an excellent post. Glad he will
        join our redneckers society. How are you and your
        stories? Hope I haven't missed any of them, especially the
        tomato gravy one. I have had lots of homefolks at my
        house for a couple of days and have been sorta lax
        about reading the board, trying to cook for them and
        all and sure did wish I could fix them some tomato
        gravy but I didn't have the recipe. Please? Can't
        believe 2HI admitted he didn't have an answer for
        someone, maybe that Badger guy, I think. I usually skip
        2hi's posts with all his 'supposin" and "what iffin"
        but I did catch the one where he admitted to no
        answer. While all the homefolks were here, I did have
        plenty of coke to serve. We even had some chicken, too.
        Where is John864 or 846? Do you know? Haven't seen him
        for a couple of days. Do you think maybe that the
        King in San Antonio would like to be a redneck, too?
        He seems to be an OK kinda guy to me. How 'bout it
        King? Best regards, Notbuffett to you and yours. Texie

    • But what you forgot to mention is that they have
      defeated the business cycle. Unlike almost every other
      major company in the entire world, they do quite well
      in upturns and downturns of the economic cycle, and
      this makes them quite unique among all
      corporations.

      Kingfisher

    • I wonder if Buffett is coming up with the same
      answer as you are for the intrinsic value of Coke. In
      his 1997 letter (1996 annual report) to shareholders,
      when KO was quite a bit cheaper than it is now he said
      the following:

      "You can, of course, pay too
      much for even the best of businesses. The overpayment
      risk surfaces periodically and, in our opinion, may
      now be quite high for the purchasers of virtually all
      stocks, The Inevitables included (Coca Cola, Gillette,
      etc.). Investors making purchases in an overheated
      market need to recognize that it may often take an
      extended period for the value of even an outstanding
      company to catch up with the price they
      paid."

      This year Buffett is quietly reducing his allocation
      to stocks. With this in mind, shouldn't we be doing
      the same? By the way, your formula is great when you
      want to hold KO for an infinite period, but what if
      you want to get out sometime in the next five or ten
      years rather than waiting for infinity.

      Finally,
      have you adjusted the net income for one time events
      in 1997 like bottling transactions resulting in one
      time capital gains and tax credits for option
      exercises?

      Also, does the fact that Buffett has not added to his
      position in recent memory lead you to believe that Coke
      might not be quite as good a buy relative to earnings
      etc., as it was 10 years ago?

      TOOHIGH2WIN

      • 1 Reply to TOOHIGH2WIN
      • The relationship between intrinsic value and
        market value is not static but changes over time. If you
        plotted Coke's intrinsic value and market value on a
        graph, you'd get two lines, both trending upwards over
        time -- but sometimes intrinsic value is higher than
        market value and other times (less frequently) market
        value is higher than intrinsic value. Why does Coke's
        intrinsic value increase in the first place (pulling Coke's
        market value up roughly with it as it goes)? Because
        Coke's owner earnings increase and, if C in PV = C / (r
        - g) increases, then PV increases. While at
        year-end 1996, Coke's intrinsic value was only slightly
        above its market value, since then Coke's intrinsic
        value is up about 65%, while Coke's market value is up
        only 50%. Once again, Coke's intrinsic value is
        outpacing its market value (what usually happens), creating
        a potentially large margin-of-safety.


        *****

        Buffett is selling his Coke???

        *****

        It
        doesn't matter how long you plan to own a stock -- the
        stock costs the same to the investor who plans to keep
        it just one day and to the investor who plans to
        keep it forever.

        *****

        Buffett last
        bought Coke in 1994.

        *****

        You have a
        point about one-time gains. However, it is more than
        offset by the fact that I used an intentionally low
        owner earnings growth rate of 8%. In actuality, Coke's
        owner earnings growth rate is closer to 20%, but
        because I wanted to keep things simple and not use a
        two-stage dividend discount model, I chose the very
        conservative 8%.

 
KO
44.88-0.69(-1.51%)Jul 26 4:00 PMEDT