Warren BuffettBuffettology by Mary Buffett and David Clark. It was published in How to Use This Book. Folly and discipline are the key elements of Warren Buffett's philosophy of investingother people's follies and Warren's discipline. Warren commits capital to investment only when it makes sense from a business perspective. It is business perspective investing that gives him the discipline to exploit the stock market's folly. Business perspective investing is the theme of this book.

This discipline of investing from a business perspective has made Warren the second richest business person in the world. Warren is the only billionaire who has made it to the Forbes list of the four hundred richest Americans solely by investing in the stock market. Over the last thirty-two years his investment portfolio has produced an average annual compounding rate of return of As humans we are susceptible to the herd mentality, and so we often fall victim to the emotional vicissitudes that propel the stock market and feed enormous profits to those who are disciplined, like Warren.

When the Dow Jones Industrial Average has just dropped points and all the sheep are jumping ship, it is investing from a business perspective that gives Warren the confidence to step into that pit of fear and greed we call the stock market and start buying. When the stock market soars to the stratosphere, it is the discipline of investing from a business perspective that keeps Warren from foolishly allocating capital to business ventures that have neither hope nor prospects of giving him a decent return on his investment.

This book is about the discipline of investing only from a business perspective. Together we will explore the origin and evolution of this philosophy. We will delve into the early writings of Warren's mentor Benjamin Graham and the ideas of other financial luminaries of this century, and travel to the present to explore the substance of Warren's philosophy. Warren made his fortune investing in the securities of many different types of businesses.

When he is unable to do that, his next choice is to make a long term minority investment in the common stock of a company that also has excellent business economics and management. What confuses people who are trying to decipher his philosophy is that he also makes investments in long-, medium-, and short-term income securities.

And he is a big player in the field of arbitrage. The characteristics of the businesses that he is investing in will vary according to the nature of his investment. A company that he is willing to invest in for arbitrage purposes may not be the kind of business in which he wants to make a long-term investment. But regardless of the type of business or the nature of the investment, Warren always uses the basics of business perspective investing as the foundation for his decision.

The purpose of this book is to lay out, step by step, the foundation of Warren's philosophy and the manner in which he applies it. This book is a tool to facilitate the task of learning, and it is our intention to teach you Warren's philosophy so that you may acquire the skills to practice this discipline yourself.

Before we start, I would like to introduce a few concepts and the terms that will be used throughout the book and give you an idea of where we will be heading as we voyage through the seas of high finance. First of all, let's take the term "intrinsic value. It fits into our scheme because Warren will buy into a business only when it is selling at a price that makes business sense given the business's intrinsic value.

Determining a business's intrinsic value is a key to deciphering guy Warren's investment philosophy. To Warren the intrinsic value of an investment is the projected annual compounding rate of return the investment will produce.

It is this projected annual compounding rate of return that Warren uses to determine if the investment makes business sense.

What Warren is doing is projecting a future value for the business, say, ten years out; then he compares the price he is going to pay or the business against the business's future, projected value, and the length of time required for the business to reach that projected value.

By using an equation that we will show you later in the book, Warren is able to project the annual compounding rate of return that the investment will produce. The annual compounding rate of return the investment is projected to produce is the value he uses to determine if the investment makes business sense when compared to other investments.

In its simplest manifestation it works like this: It is this projected annual compounding return of You may be wondering: If Warren's intrinsic value model requires a projection of a business's future value, then how does he go about determining that future value?

That, my friends, is the crux of solving the enigma of Warren's investment philosophy. Just how does one determine the future earnings of a business in order to project its future value and, thus, its intrinsic value? This problem and Warren's method of solving it will be the focus of much of this book.

In short, Warren focuses on the predictability of future earnings; and he believes that without some predictability of future earnings, any calculation of a future value is mere speculation, and speculation is an invitation to folly. Warren will make long-term investments only in businesses whose future earnings are predictable to a high degree of certainty. After we have learned what Warren believes are the characteristics of a business with predictable earnings, we will learn how to apply the mathematical calculations he uses for determining the business's intrinsic value and what the return on his investment will be.

The nature of the business enterprise and whether it can be bought at a price that will yield a sufficient return will determine the investment's worth and whether or not we are investing from a business perspective. If I were to sum up Warren's great secrets for successful investing from a business perspective, I would offer up the following: Warren will invest long-term only in companies whose future earnings he can reasonably predict.

You know that one already. Warren has found that the kind of company whose earnings he can reasonably predict generally has excellent business economics working in its favor. This allows the business to make lots of money that it is free to spend either by buying new businesses or by improving the profitability of the great business that generated all the cash to begin with.

These excellent business economics are usually made evident by consistently high returns on shareholders' equity, strong earnings, the presence of what Warren calls a consumer monopoly, and management that functions with the shareholders' economic interests in mind. The price you pay for a security will determine the return you can expect on your investment. The lower the price, the greater your return.

The greater the price, the lower your return. We will explore this point in great detail in Chapter 7. Warren, unlike other investment professionals, chooses the kind of business he would like to be in and then lets the price of the security, and thus his expected rate of return, determine the buy decision.

This is like Warren in high school identifying a girl he wants to date and then waiting for her to break up with her boyfriend before beginning his pursuit. How Warren determines what is the right business and the right price to pay for it is what this entire book is about.

Last but not least, Warren found a way to acquire other people's money to manage so that he could profit from his investing expertise. He did this by starting an investment partnership and later by acquiring insurance companies. I'm going to teach what I have gleaned about how he does all the above, and if I have done my job, at the end of this book you will understand Warren and the craft of investing from a business perspective.

Now, I know a lot of you think that in order to get rich you have to make tons of money overnight. That is not the case. You just have to earn consistently above-average annual rates of return over a long period of time. I'll also show you how to start an investment partnership, which is one of the keys to getting really wealthy, and a method Warren used with great skill.

So let us begin your education. Let's explore and learn the world of Buffettology. The Only Two Things You Need to Know About Business Perspective Investing: What to Buyand at What Price. If you can answer these two questions, you've got it made.

What to buy, and at what price? Seems simple, doesn't it? The problem is that Wall Street, with its investment bankers and brokers, functions basically as salesmen working for a commission.

Obviously they want to get the highest price possible for the goods they are selling. The buyer is almost ensured of never getting a bargain. New issues are priced at their maximum to allow the issuing company to receive the most money for its shares and the investment bank to receive the biggest commission.

The stockbroker who calls you on the phone is a commission broker, and like all commission brokers, he is interested only in selling the priciest items that he can.

If the stockbroker is selling you a new issue, then you know immediately that it has been fully priced by the investment bank and you are not getting any bargain. If the stockbroker is selling you an issue that his research department is backing, then you know that you are following the herd mentality.

For, as the stock price rises, the enthusiasm of the stockbroker will increase as well.

Warren, on the other hand, loses enthusiasm for any investment as the price rises. Interesting, isn't it, that the man who has made the most money in this game has a strategy opposite to that of the guy who calls you on the phone and is trying to sell you something!

For the oddest of reasons, Wall Street and the individual investor have jumbled the questions of what to buy and at what price into a myriad of financial pyrotechnics that befuddle the imagination. They screw it up by focusing entirely on the question of what to buy and totally ignoring the question of price. Like jewelry or art salesmen, they let the aesthetics of the form take precedence over the question of function.

The Wall Street broker treats the financial economics of an enterprise as though they were aesthetic qualities and, almost without fail, separates the price entirely from the picture.

They never call up and say, "XYZ is an excellent company but its price is too high," because, the truth be known , they probably think XYZ stock is an excellent buy at any price, which is about as dumb as you can get in this game.

Remember, the stockbroker is trying to sell you on the prospects of the stock rising in price, and this is where the aesthetic qualities of the economics of the business come into play. The broker creates the excitement with the economics, and you, the investor, salivating like Pavlov's dog, give him your money. In all that time no one ever said boo about whether or not you have received any true value for your money. But what does value have to do with aesthetics? However, if function had been your first question, you would view any investment as Warren doesfrom a business perspective.

The nagging question should not be about the rising price of the stock but about whether or not the underlying business is going to make any money. And if so, how much? Once that figure has been determined, the return given for the price asked can be calculated. It never ceases to amaze me that Wall Street can sell to investors, at wildly ridiculous prices, companies that are just starting out and won't have any earnings for some time.

This happens while companies that show a long history of earnings and growth go for a fraction of the price of their speculative cousins. For Graham the questions of what to buy and at what price were mutually dependent. However, Graham placed a greater emphasis on letting price dictate the what-to-buy decision than does Warren. As long as the company had stable earnings, the per share asking price would determine what could be bought, and Graham had little concern about the nature of the business.

Graham didn't care if it manufactured or sold cars, batteries, airplanes, rail cars, or insurance, as long as the price of the company's stock was comfortably below what he thought it was worth. For Graham a low enough price compensated for poor inherent business economics.

Graham developed an arsenal of different techniques to determine the worth of the business in question. Everything from asset values to earning power found its way into his calculation of intrinsic value. Graham calculated the value of a company and then determined if the asking price was low enough for him to make a sufficient profit.

Sufficient profit potential afforded him that he called the "margin of safety. WARREN 'S WINNING WAY. This is a key concept, so pay attention! As we know, first he discovers what to buy and then he decides if the price is right. A real-life analogy would be if Graham went to the discount store to shop for a bargain, any bargain, as long as it's a bargain.

You have to know the feeling. Even though you live in Florida and will probably never use a snowblower, the price is so low that you can't pass it up. That is the essence of who Graham was and how he chose his investments. Thus, the only time he can be found in a discount store is when he's checking it out to see if anything he needs is selling cheap.

Warren functions in the securities market the same way. He already knows what companies he would like to own. All he is waiting for is the right price.

With Warren the what-to-buy question is separate from the at-what-price question. He answers the what-to-buy question first, then determines if it is selling at the right price. Now go back and read it one more time! The Myth of Diversifications Versus the Concentrated Portfolio. Warren believes that diversification is something people do to protect themselves from their own stupidity. They lack the intelligence and expertise to make large investments in just a few businesses, so they must hedge against the folly of ignorance by having their capital spread out among many different investments.

As we know, Graham's investment strategy required that he have literally one hundred or more stocks in his portfolio. He did this to hedge against the possibility that some of his investments would never perform, as businesses and as stocks. The nature of the business, he felt, was locked into the numbers, and he was not all that concerned with really getting to know the businesses he owned.

Warren followed Graham's strategy for a while but in the end found that it was more like owning a zoo than a stock portfolio. Fisher, though agreeing that some diversification was necessary, thought that diversification as an investment principal was way oversold. He pointed out that some cynics thought this was because it was a simple enough theory for even stockbrokers to understand. Fisher agreed that investors, responding to the horrors of putting all their eggs into one basket, ended up spreading out their eggs into dozens of different baskets, with many of the baskets ending up containing broken eggs.

Also, it was impossible to keep an eye on all the eggs in all the baskets. Fisher thought that most investors had been so oversold on diversification that they ended up owning so many stocks that they had little or no idea of what kind of businesses they had invested in. Warren was greatly influenced by the writings of the late, great British economist john Maynard Keynes.

Keynes, a person of noted expertise in the field of investments, said he had made the majority of his money in just a few different investmentsthe underlying businesses whose investment value he understood. Warren has adopted the concentrated-portfolio approach , which means that he holds a small number of investments he really understands and intends holding for a long period of time.

This allows the question of whether to allocate capital to an investment to be approached with the utmost seriousness.

Warren believes that it is the seriousness with which he addresses the questions of what to what to invest in and at what price that decreases the risk. It is his commitment to the strategy of investing only in exceptional businesses at prices that make business sense that reduces his chances for loss. Warren has often said that a person would make fewer bad investment decisions if he were limited to making just ten in his lifetime.

You would put a little work into making those ten decisions, don't you think? It's amazing that intelligent, hardworking individuals think nothing of taking a large portion of their net worth and investing it in a company they know little or nothing about. If you ask them to invest in a local business, they would pepper you with questions. But let some stockbroker call them on the phone, and the next thing you know, they are partial owners of some exotic business.

Baruch, by the way, lived to be a very old and a very, very wealthy man. When Should You Sell Your Investments? The Wall Street folklore that surrounds selling has something to do with the old adage that no one ever went broke by selling at a profit. Warren might respond that no ever got really wealthy that way either.

That last sentence should have caused a big question mark to appear in your head. Let us see why Warren thinks that this old adage won't make you superrich. Parts of this chapter appear in other sections of the book. We thought it would be beneficial to bring all thoughts on selling under one roof.

So if it looks familiar, it probably is. THE GRAHAM APPROACH TO SELLING. Warren originally followed Graham's approach to selling. Graham, as we know, advocated selling a security when it reached its intrinsic value.

Graham reasoned that a security had little or no profit potential past that point, and that one would be better off finding another undervalued situation. He would take the proceeds and reinvest them in another undervalued situation.

As we noted earlier, Graham discovered that when you bought a stock that was selling below its intrinsic value, the longer you had to hold the stock, the lower the projected annual compounding rate of return on your investment would be. However, if it took two years for the share price to rise to the stock's intrinsic value, then your annual compounding rate of return would drop to If it took three years, your annual compounding rate of return would drop to The longer it took, the lower your annual compounding rate of return.

Graham's solution to this problem was to buy a company's stock only when its market price was sufficiently below the stock's intrinsic value to afford you a margin of safety. The margin of safety was there to protect you if the stock took a long time to realize its full intrinsic value.

How long you thought the investment would take to rise to its intrinsic value determined the size of the margin of safety needed. If a long time is anticipated, then a large margin of safety is needed; but if a short time is expected, then a smaller margin of safety is probably adequate. Graham, however, had one additional problem.

What happens if the stock price never rises to its intrinsic value? What happens if the market refuses to realize the stock's full intrinsic value? How long should one wait? His answer was two to three years. He reasoned that if the stock hadn't reached its intrinsic value by then, it probably never would.

In that case, it was better to sell the stock and find a new situation. Warren found that these remedies didn't really solve the realization-of-value problem. He found that more often than not, he was left holding dogs that never rose to their projected intrinsic value.

And even if they did, once he sold them, the IRS would slap him with a capital gains tax. So, he found Graham's solutions to be wanting. Charlie Munger and Philip Fisher advocated another solution to this problem. They argued that if one bought an excellent business that was growing, and the management functioned with the shareholders' financial gain as their primary concern, then the time to sell the business was neverunless these circumstances changed or a better situation availed itself.

They believed that superior results could be had by following this strategy, which allowed for the investor to fully benefit from the compounding effect of the business profitably employing its retained earnings. In order for Warren to implement this strategy he was required to leave the Graham fold and stop buying any situation solely on the basis of price.

He began to base his investment decisions on the economic nature of the business. The excellent business with high rates of return on equity, identifiable consumer monopoly, and shareholder-oriented management became his primary target. Price still dictated whether the stock would be bought and what Warren's annual compounding rate of return would be.

But once the purchase was made, it could be held for many years as long as the economics of the business didn't change dramatically for the worse. These are companies that he sees as having an expanding value that will benefit him greatly over the long term.

Even though they periodically sell at prices in excess of their Grahamian intrinsic value, Warren has continued to own them. One removes weeds from the garden, not the shoots of green that are flowering and bearing fruit. BEAR AND BULL MARKETSWHEN TO SELL.

Many investors continually fall victim to the threat that the next bear market is right around the corner. Maybe it starts in the Wall Street Journal or on Wall Street Week. Your stockbroker is calling to tell you to take a defensive position, which means you have to move some of your assets into cash.

Brokers love this because it lets them earn a commission on the sale of the stocks that produce the cash. They also make another commission later on when they reinvest the cash for you. Fisher thought this was a stupid way to conduct your affairs. First of all, it is unlikely that the bear market will ever occur on schedule; and that the Wall Street fortune-tellers are wrong as much as they are right.

And if you sell your great investment, that bear market just around the corner may end up being a bull market instead, and you just missed it. But wait, you say, I'll just get back into the stock if the bear market doesn't materialize, and if it does, I can buy it back at a lower price. First of all, when you sold the stock, you got whacked for a capital gains tax and a broker's commission, which means that you don't have as much money as you started out with. If the bear market doesn't materialize, you have to come up with more money.

Additionally, if the bear market does come, and you want to re-buy the stock, your stock has to drop considerably in price to make up for the capital gains tax and the broker's commission you paid. Fisher also argues that people he knows seldom get back into their investments even if the bear market shows up. People who react to fear usually are left in a state of paralysis when soothsayers' predictions come true. Bernard Baruch summed up his feelings on this subject with this advice: This can't be doneexcept by liars.

He can do this because he buys into a business on the basis of price. If the price is too high, the investment won't offer a sufficient rate of return and he won't buy in. Where the market is on any given day doesn't really matter to him. He doesn't think about it.

Instead, he thinks about the business he is considering investing in and whether he can get it at the right price. Warren is aware that great buys can show up even in a raging bull market, but he has also found that a bear market, where lots of companies are being sold cheap, offers him his greatest opportunity to find a really spectacular deal.

In the great crash of , when all the market went crazy, running off a cliff, Warren was standing at the bottom of that deep abyss waiting for a business he was in love with to drop by. And sure enough, as we told you, the price of Coca-Cola stock got hammered and Warren jumped on it with a billion dollars. His eyes saw opportunity where others saw only fear. And he could do this because his investment decisions are made from a business perspective.

As we said, Warren is interested only in long-term ownership of businesses that possess some sort of consumer monopoly and allow for continuous per share earnings growth, through either expansion of operations or stock buybacks. Because continuous per share earnings growth eventually equates to higher per share prices for the company stock, Warren discovered that it makes more sense to hold an investment for as long as possible, even when the market places a very high value on the stock.

Warren wants the compounding to go on as long as possible. Sure, over the short term he could sell and make a handsome profit, but he is after an outrageous profit, the kind that makes you one of the richest people in the world.

To get that rich you have to get your capital to compound at a high annual rate of return for a long time! When a Downturn in a Company Can Be an Investment Opportunity. What throws most Warren watchers is that he will sometimes buy into a business when prospects seem the bleakest. He did this most recently with his early s purchase of stock in Wells Fargo Bank. Previous investments of this kind include the purchase of stock in American Express in the late sixties, after the salad oil scandal which will be explained later , and the purchase of his interest in GEICO in the seventies.

That is to say, if a company had a bad year, the stock market would beat the price of the stock way down, even if all the preceding years had produced excellent results.

To Graham this presented great opportunity to the investor who could take a long-term view. Warren discovered that short-term volatility is what creates opportunity for the long-term investor. Let me give you a practical example. Let's say that you own a small ski resort. You also occasionally had a really bad year when it didn't snow and you didn't make any money. Would you value your ski resort business for less money in the year that it didn't snow and you didn't make any money?

You know that occasional weather cycles will once in a while bring you a really bad year, just as they will bring you an occasional really great year. Those are just the ups and downs of your business. And if you were valuing your business, you would take those ups and downs into account.

Makes sense, doesn't it? But if your ski resort was a publicly traded company, the stock market, being short-term motivated, would revalue your business every year as the earnings fluctuated.

In really great years they would value the ski resort at a lot more and send the price of the stock sky-high. Likewise, in bad years, when it didn't snow, they would hammer the price of the stock into the ground. This kind of event happens periodically to almost all businesses, regardless of whether they are the commodity type or have a consumer monopoly working in their favor.

The television and newspaper industry are dependent on advertising to produce income. However, advertising rates and revenue fluctuate with the business activity of the entire economy. If the economy falls into a recession, then advertising revenues fall as well, and newspapers and television networks make less money. Seeing this loss of revenues, the stock market reacts, causing the stock price of the newspaper or television company to plummet.

Because of a business recession, advertising revenues started to drop, and Capital Cities reported that its net profit for would be approximately the same as in In Capital Cities and the Walt Disney Company agreed to merge. The same kind of event can occur in the banking industry. Changes in interest rates can cause fluctuations in a bank's earnings for a particular year.

Banks are also susceptible to the real estate cycle of boom and bust. The real estate market has periods of great expansion followed by periods of great contraction, which are followed by long periods of relative calm.

But an industry-wide recession is different from an individual bank becoming insolvent from poor business practice. To a large money-center bank, like Wells Fargo, such a problem is far more serious than it is to a middle-size regional bank.

One brings the specter of an entire economy collapsing, the other a regional calamity. Money-center banks are key players in the commercial world, These banks occupy a permanent and very vital niche in our economy. Not only do they do business with tens of thousands of individual customers and businesses; they also act as the banker to smaller banks. Most money-center banks are part of an elite group of financial institutions that are allowed to buy bonds from the U.

Treasury and then resell them to other banks or institutions, kind of like a master toll bridge. In the eyes of the Federal Reserve Bank, they are the center of the financial universe. If one is poorly run and is likely to become insolvent, the Federal Reserve will do everything in its power to force it to merge with another money-center bank.

But in a recession, when all banks are having problems, the Federal Reserve has only one solution, and that is to loosen the money supply and try to keep the money-center banks afloat. What most people don't realize is that banks borrow money from other banks. The Federal Reserve Bank has what is called the discount window, which is where banks traditionally go when they are in trouble and need to borrow money.

The discount window is a source of cheap money for banks. This allows them to borrow money from the Federal Reserve Bank and then loan it out at a profit. During periods of normal banking activity, if a hank shows up too many times at the discount window, a band of banking regulators will descend down upon it.

But in times of a nationwide recession, the discount window is one way that the Federal Reserve Bank ensures that key money-center banks stay in business. Remember, in an industry-wide recession everyone gets hurt. But the strong survive and the weak are removed from the economic landscape. One of the most conservative, well-run, and financially strong of the key money-center banks on the West Coast, and the eighth largest bank in the nation, is Wells Fat-go.

When a bank sets aside funds for potential losses it is merely designating part of its net worth as a reserve for potential future losses. It doesn't means those losses have happened, nor does it mean they will happen. What it means is that there is a potential for the losses to occur and the bank is prepared to meet them.

Losses did eventually occur, but they weren't as bad as Wells Fargo prepared for. In they wiped out most of Wells Fargo's earnings. What Warren saw in Wells Fargo was one of the best-managed and most profitable money-center banks in the country selling in the stock market for a price that was considerably less than comparable banks were selling for in the private market.

And though all banks compete with one another, money-center banks like Wells Fargo, as we said, have a kind of toll bridge monopoly on financial transactions. If you are going to function in society, be it as an individual, a mom-and-pop business, or a billion-dollar corporation, you need a bank account or a checking account, and maybe a car loan, or a mortgage. And with every bank account, checking account, car loan, or mortgage comes the banker, charging you fees for the myriad services he provides.

Warren ended up with a pretax annual compounding rate of return of approximately You have to know what you are interested in before you go shopping. But sometimes a twist in the business cycle creates a few down years for what is usually an excellent business. And the stock market flips out and slams the price of the stock into the ground.

For Capital Cities it was a general recession that caused a drop in advertising revenues. But this sort of thing has happened before.

The same recession caused a collapsing real estate market and in the process caused the entire banking industry to suffer huge losses. But Wells Fargo wasn't going to vanish overnight; it was too well run and too key a player in the banking game. The weaker banks vanish long before the giants fall. The financial systein's self-interest and the Federal Reserve see to that. So, what's the point? The point is this: Recessions are hard on the weak, but they clean the field for the strong to take an even larger share when things improve.

Occasionally, a company with a great consumer monopoly going in it, favor does something that is both stupid and correctable. From to the mids GEICO made a fortune insuring preferred drivers by operating at low cost and eliminating agents by operating via direct mail.

But by the early s new management decided that it would try and grow the company further by selling insurance to just about anyone who knocked on their door.

This new philosophy, of insuring any and all, brought GEICO a large number of drivers who were accident-prone. More accidents meant that GEICO would lose more money, which it did.

In response to this crisis, GEICO's board of directors hired Jack Byrne as the new chairman and president. Once on board, he approached Warren about investing in the company. Warren had only one concern, and that was whether GEICO would drop the unprofitable practice of insuring any and all drivers and return to the time-tested format of insuring just preferred drivers at low cost by direct mail.

Byrne said that was the plan, and Warren made his investment. A different type of event occurred at American Express in the mids. When De Angelis failed to pay back the loans, his creditors moved to foreclose on the salad oil.

But to the surprise of the creditors, the collateral they had loaned money against didn't exist. Since American Express had inadvertently verified the existence of the nonexistent oil, it was held ultimately responsible to the creditors for their losses.

This loss essentially sucked out the majority of American Express's equity base, and Wall Street responded by slamming its stock into the ground. Warren saw this and reasoned that even it the company lost the majority of its equity base, the inherent consumer monopolies of the credit card operations and travelers checks business still remained intact.

This loss of capital would not cause any long-term damage to American Express. Think of it this way. The stock market, hearing the news of your judgment, would kill Coca-Cola's stock price. But in truth this loss would have little or no effect on the amount of money Coca-Cola would make in The intrinsic consumer monopoly Coca-Cola possesses would still be intact.

But instead of paying out the dividends to its shareholders, Coca-Cola would have paid it out to you. By the time rolls around, no one will have remembered your judgment, and the price of Coca-Cola's stock will have returned to its prejudgment price. How soon they forget! The lesson here is that the volatility of a company's stock price caused by a recession, as in the case of Capital Cities or Wells Fargo, or the odd event, as in the case of GEICO or American Express, can create an opportunity for the business perspective investor who has an eye on the long term.

What You Need to Know About the Management of the Company You May Invest In. Let's talk about those folks to whom you have entrusted your moneythe management of the business you have invested in.

Poor businesses often are just that, and no amount of managerial talent is going to make a difference. Warren uses the analogy of ship captains to make his point.

If you had two ship captains and one was much more experienced than the other, who do you think would win a race if you put the more experienced captain in a dinghy and the less experienced captain in a speedboat?

It doesn't matter how good management is if the business suffers from inherently poor economics. The same can be said of businesses with exceptional economics, in that it is hard for even inept managers to foul up the economics of the business.

Warren once said that he is interested in investing only in businesses whose inherent economics are so strong that even fools can run them profitably. It is the business's economics , not its management, that the investor should first look to in determining whether the business is one to be considered for investment.

But as the old saying goes, not only do you want management that is hardworking and intelligent; it must be honest, too. For if it isn't honest, the first two qualitieshardworking and intelligentare going to steal you blind.

Honesty probably is the single most important trait of management. Honest managers will behave as if they are owners. They are less likely to squander the shareholders' assets. One of the key ingredients to successful investing is that management function from the same premise that you and Warren are from a solid business perspective. Warren believes that one of the essential benchmarks that indicate management's good intentions is the use of excess retained earnings for the purchase of the company's stock when it makes business sense to do so.

When a company buys back its own stock at prices that give it a better return than other investments it could make, then it is a good thing for the investors who continue to own the stock. Their piece of the pie just got bigger, and they didn't have to do anything. Sounds good, doesn't it! Let's look at Capital Cities' management to see how this works. Its justification for spending the shareholders' money in this fashion was that since Capital Cities was a broadcasting business, it should be investing only in a business that it understands-in this case, broadcasting.

The problem is that broadcasting companies in the private market during this time were all selling at very high prices, in contrast with the public market the stock market , in which companies were selling at a considerable discount from their non-publicly-traded, private-market cousins.

Capital Cities' management saw that its stock was selling at a discount to the prices being paid in the private market. So the management of Capital Cities bought its own stock, which was a better deal than buying the stock of the privately held companies. This increased the wealth of the shareholders who kept their shares. Again, you need honest management that views its function as increasing shareholder wealth and not fiefdom building.

The great Wall Street sage of the s and s Bernard Baruch, when listing his investment criteria, said, "Most important is the character and brains of management. I'd rather have good management and less money than poor managers with a lot of money. Poor managers can ruin even a good position.

In the end, management has complete control over your money. If you don't like what the managers are doing with it, you can either vote them out by electing a new board of directors or sell your stock and get out, which really is voting with your feet.

Nine Questions to Help You Determine If a Business Is Truly an Excellent One. There is a nature to the beast that we are stalking. Warren has discovered that the excellent business has certain other characteristics that help identify it.

I have found that it is easier to break this part of the analysis into a series of questions. Warren uses a similar line of questioning when he is trying to determine the presence of the consumer monopoly, exceptional business economics, and shareholder-oriented management.

Let's walk through the questions: Does the business have an identifiable consumer monopoly? Are the earnings of the company strong and showing an upward trend? Is the company conservatively financed? Does the business consistently earn a high rate of return on shareholders' equity? Does the business get to retain its earnings? How much does the business have to spend on maintaining current operations?

Is the company free to reinvest retained earnings in new business opportunities, expansion of operations, or share repurchases? How good a job does the management do at this?

Is the company free to adjust prices to inflation? Will the value added by retained earnings increase the market value of the company? Nine thoughts to spark revelation. Kind of like trying to figure out if your blind date is a hopeful for the altar. Has a good job? Does he or she snore? We do the same thing when we allocate capital to investment. As Warren says, in the field of investing it is better that one act like a Catholic and marry for life.

That way one makes sure going in that the partner chosen is one worth keepingbecause there is no getting out. So let's look at these questions in detail. We have discussed the consumer monopoly and the concept of the toll bridge. It is the first question that you have to ask: Is there a consumer monopoly here?

It will be either a brand-name product or a key service that people or businesses are dependent on. Products are much easier to identify than services, so let's start with those. Go stand outside a convenience store, supermarket, pharmacy, bar, gas station, or bookstore and ask yourself, What are the brand-name products that this business has to carry to be in business?

What products would a manager be insane not to carry? Now go into the establishment and examine the product, which usually has been shoved in your face by advertising. If it's got a brand name that you immediately recognize, then the chances are good there is some kind of consumer monopoly at work. Name me a newspaper you can buy at any newsstand in America USA Today.

Name me a soda that you can buy anywhere in the world Coca-Cola. Name me a brand of cigarette that every convenience shop carries Marlboro. Who owns the rights to the Little Mermaid movie that your children can't seem to get enough of? What kind of breakfast cereal is your child eating? What kind of razor blades do you use every morning? Just take a walk around the local supermarket, and your imagination should go wild.

Companies that provide services that constitute consumer monopolies are much harder to identify. Key places to look are in the field of advertisingtelevision networks and advertising agenciesand the financial services providers, such as credit card companies. Don't worry, there is an entire chapter just ahead that tells you exactly where to look for companies that have consumer monopolies.

But just because the business has a brand-name product working in its favor does not mean that it is an excellent business. There are dozens of ways for management to fail to maximize the magic of a consumer monopoly.

A great product is where you start, but a great product doesn't necessarily mean a great company. ARE THE EARNINGS OF THE COMPANY STRONG AND SHOWING AN UPWARD TREND? A consumer monopoly is a great thing, but management may have done such a poor job running the rest of the company that annual per share earnings fluctuate wildly.

Warren is looking for annual per share earnings that are strong and show an upward trend. Does the per share earnings picture of the company in question look like Company I, or Company II? Warren would be interested in Company I and not Company II. Company II's per share earnings have been way too erratic to predict with any certainty.

Regardless of any competitive advantage Company II's products may have, something is going on to cause earnings to gyrate so much. Company I shows a per share earnings picture that may indicate not only a company that possesses a consumer-monopoly product or products, but also a company whose management can turn that advantage into real shareholder value. Warren likes companies that are conservatively financed.

If a company has a great consumer monopoly, then more than likely it is spinning off tons of cash and is in no need of a long-term debt burden. Warren's star performers like Coca-Cola and Gillette both carry lung-term debt of less than one times current net earnings. Sometimes an excellent business with a consumer monopoly will add a large amount of debt to finance the acquisition of another business, such as when Capital Cities more than doubled its long-term-debt burden to acquire the ABC television and radio networks.

In a case like this you have to figure out if the acquisition is also a consumer monopoly, which it was in this case. But if it isn't, watch out! When long-term debt is used to acquire another company, the rules are: With two consumer monopolies spinning off lots of excess profits, it doesn't take long for even mountains of debt to be reduced to molehills. This is because the commodity-type business will suck off the profits of the consumer monopoly business to support its poor economics, thus leaving little to pay down the newly acquired debt.

The exception to this is when the management of a commodity-type company uses the company's cash flow to acquire a consumer-monopoly-type business and then after the marriage, the management jettisons the cash-hungry commodity type business.

This is because neither can produce sufficient profits to climb out of debt. When looking for an excellent business, look for companies that possess a consumer monopoly and are conservatively financed. If the company with a consumer monopoly is using large amounts of long-term debt, it should be only to acquire another company with a consumer monopoly. Warren has figured out that high returns on shareholders' equity can produce great wealth for shareholders.

Thus, Warren is seeking to invest in companies that consistently earn high returns on shareholders' equity. To fully understand why Warren is so interested in high returns on shareholders' equity, let us work through the following.

Shareholders' equity is defined as a company's total assets less the company's total liabilities. It's like the equity in your house. When you rent your house out, the amount of money that you earn from the rent, after paying your expenses, mortgage, and taxes, would be your return on equity.

And below average is not what we are looking for. What Warren is looking for in a business is consistently higher than-average returns on equity. Let's look at some of the companies that have caught Warren's interest in the past and see what kind of return on equity they were getting. Hershey Foods has long fascinated Warren. It has an average annual return on equity for the last ten years of A company like Philip Morris, the tobacco and food conglomerate, has had an average annual return on equity for the last ten years of Warren believes that a consistently high return on equity is a good indication that the company's management not only can make money from the existing business but also can profitably employ retained earnings to make more money for the shareholders.

Warren is not after a company that occasionally has high returns, but one that consistently has high returns. Analyzing the Company's Return on Equity. Does the return-on-equity picture of the company in question look like Company I, or Company II. Company I Company II. Warren would be interested in Company I and not Company II Company II's return on equity is way too low.

Company I shows a very high rate of return on equity, which indicates that it benefits from possessing a very strong consumer monopoly. There is a great deal more to understanding why Warren is interested only in companies that get high returns on equity, and we go into great detail on this subject in the second part of the book.

High rates of return on equity are indicative of the excellent business. DOES THE BUSINESS GET TO RETAIN ITS EARNINGS? In the edition of Security Analysis , Graham introduces his readers to Edgar Lawrence Smith, who in wrote a book on investing entitled Common Stocks As Long-Term Investments Macmillan, Smith put forth the idea that common stocks should in theory grow in value as long as they earn more than they pay out in dividends, with the retained earnings adding to the company's net worth.

With this is mind, Smith explains the growth of common stock values as arising from the accumulation of asset values through the reinvestment of a corporation's surplus earnings in the expansion of its operations.

Graham, however, warns us that not all companies can reinvest their surplus earnings in expansion of their business enterprises. Most, in fact, must spend their retained earnings on simply maintaining the status quo through the replenishment of expiring plants and equipment. We will address this issue further on. Predicting future earnings of any enterprise can be very difficult and given to great variance.

This means that making a future prediction of earnings can be fraught with potential disaster. Warren concluded that Graham's assessment of Smith's analysis was correct for a great majority of businesses. However, he found that under close analysis some companies were an exception to the rule. Warren found that these exceptions over a long period of time were able to profitably employ retained earnings at rates of return considerably above the average. In short, Warren found a few businesses that didn't need to spend their retained earnings upgrading plant and equipment or on new-product development, but could spend their earnings either on acquiring new businesses or expanding the operations of their already profitable core enterprises.

We want to invest in businesses that can retain their earnings and haven't committed themselves to paying out a high percentage of their profits as dividends. This way the shareholders can benefit from the full effects of compounding, which is the secret to getting really rich. As we said, making money is one thing, retaining it is another, and not having to spend it on maintaining current operations is still another.

Warren found that in order for Smith's theory to work he had to invest in companies that 1 made money, 2 could retain it, and 3 didn't have to spend those retained earnings on maintaining current operations. Warren discovered that the capital requirements of a business may be so demanding that the company ends up having little or no money left to increase the fortunes of its shareholders.

Let me give you an example. Warren used to teach this lesson when he conducted a night class on investing at the University of Nebraska at Omaha Business School. He would lecture on the capital requirements of a company and the effect that it had on shareholder fortunes. But a company like Thomson Publishing, which owned a bunch of newspapers in one-newspaper towns, made lots of money for its shareholders. This was because once a newspaper had built its printing infrastructure it had little in the way of capital needs to suck away the shareholders' money.

This meant that there was lots of cash to spend on buying more newspapers to make its shareholders richer. The lesson is that one business grew in value without requiring more infusions of capital and the other business grew only because of the additional capital that was invested in it. The company also issued million additional shares of its common stock.

What did all this do for increasing the shareholders' wealth? Factor in inflation and taxes, and your invested capital ends up losing real value. General Motors has huge capital requirements because the products that it is making, cars and trucks, are constantly changing. This means GM's manufacturing plants constantly have to be retooled to accommodate the new design changes, which means an expenditure of great sums of money just for GM to stay in business.

One final story to drive home the point. About a year ago I was having lunch with the owner of a company that laid asphalt roads for the state. What Warren wants is a business that seldom requires replacement of plant and equipment and doesn't require ongoing expensive research and development. He wants a company that produces a product that never goes obsolete and is simple to produce and has little or no competition: Predictable product, predictable profits.

Another of Warren's keys to defining a great business is that a company has the capacity to take retained earnings and reinvest them in business ventures that will give them an additional high return. Remember young Warren and the pinball machine. If he just kept that one pinball machine and never expanded the business, all the money he earned from the single pinball machine would go into a bank account and earn whatever the rate of return the bank was paying.

Warren believes that if a company can employ its retained earnings at above-average rates of return then it is better to keep those earnings in the business. He has stated many times that he is not at all unhappy when Berkshire's wholly owned businesses retain all of their earnings, as long as they can utilize internally those funds at above-average rates of return. Warren has taken this philosophy and applied it to companies in which he has a small minority interest.

He believes that if the company has a history of profitable use of retained earnings, or a reasonable promise of profitable use in the future, it would be to the shareholders' advantage to have the company retain all the earnings it can profitably employ. Be aware that if a company has low capital requirements but no prospects for capital employment that would bring a high rate of return, or if the management has a history of investing retained earnings into projects of low profitability, then Warren believes that the most attractive option for capital employment would be to pay out the earnings via dividends or use them to repurchase shares.

When retained earnings are used to buy back shares, the company is in effect buying its own property and increasing future per share earnings of the owners who didn't sell. If you have a partnership and there are three partners, you each in effect own one third of the partnership.

Share repurchases cause per share earnings to increase, which results in an increase in the market price of the stock, which means richer shareholders. Chapter 40 gives a detailed explanation of the economics that motivate share repurchase programs and why Warren is a big fan of them.

Warren's preference is to invest in cash cows; these are very profitable businesses that require very little in further research and development or replacement of plant and equipment. The best cash cows have the ability to invest in or acquire other cash cows. Take RJR Nabisco and Philip Morris. Both own cigarette businesses that are cash cows and generate lots of retained earnings.

If they decided to reinvest those earnings in, say, the automotive business, they could expect large expenditures for a long time before generating a profit from the operations. However, they have chosen instead to take their tobacco-generated earnings and acquire cash cow food companies like Nabisco Foods, General Foods, and Kraft Foods, as well as myriad other brand-name food purveyors. Another good example of this strategy is the Sara Lee Corporation, which not only makes brand-name cheesecake but has managed to build a portfolio of other consumer brand names such as L'eggs, Hanes, and Playtex.

Capital Cities, before it merged with Disney, used its cash cow cable TV business to buy the ABC television network, another cash cow. For a long time, acquiring other media properties was where it spent most of its money.

It did this with its shareholders' money because for a long time TV and radio stations were fantastic cash cows. Build a TV station and it lasts for forty years.

Up until recently, media properties' consumer monopoly was protected from competition by the federal government. However, recent expansion of cable, satellite, and interactive TV through the use of telephone lines calls into question whether or not the big three networksABC, CBS, and NBCcan protect their business from all the new competition. There is a story about Tom Murphy, CEO of Capital Cities, sitting around Warren's home in Omaha, watching TV.

Someone said to him, "Isn't it amazing that so many advances have been made in the field of broadcast technology? Warren believes that the networks may not be the fantastic businesses that they once were but they are still great businesses. Whether or not the management of the company can utilize its retained earnings is probably the single most important question you must ask yourself as a long-term investor in businesses.

Commitment of capital to a company that has neither the opportunity nor the managerial talent to grow its retained earnings will cause your investment boat to become dead in the water. IS THE COMPANY FREE TO ADJUST PRICES TO INFLATION? Inflation causes prices to rise. The problem with the commodity type business is that while prices for labor and raw material increase, it is possible that overproduction will create a situation in which the company has to drop the prices of its products in order to stimulate demand.

In a case like this, the cost of production is sometimes in excess of the price the product will fetch in the marketplace. And so the company loses lots of money. This usually results in the company cutting back production until the excess supply dries up. But that takes time. The laws of supply and demand work, but not overnight. In the meantime the losses pile up and the viability of the business diminishes. Ranchers are constantly faced with this dilemma.

The price of live cattle is dropping, but the costs of feed, fuel, labor, insurance, veterinarians, and grazing land keep increasing. Miscalculate what the price of cattle will be next fall, and the family ranch may end up in foreclosure. This situation occurs periodically in the airline business. Airlines commit themselves to all kinds of heavy fixed costs.

From airplanes to fuel to union contracts for pilots, ground crews, mechanics, and attendantsall cost lots of money, and they all increase in cost with inflation. But along comes a price war and the airlines have to start cutting ticket prices to stay competitive. Want to fly from New York to Los Angeles? There are a half dozen or more airlines competing for your business.

If one drops prices significantly, they all end up losing. Even though the cost of airplanes, fuel, pilots, grounds crews, mechanics, and those terrible airline meals had more than quadrupled in the last thirty years, my ticket, thanks to a price war, got cheaper.

But the airline that sold it to me didn't get any richer. Now you know why so many airlines go under. With a commodity-type business it is possible to have the cost of production increase with inflation while the prices the business can charge for its products decreases because of competition.

That way its profits remain fat, no matter how inflated the economy gets. WILL THE VALUE ADDED BY RETAINED EARNINGS INCREASE THE MARKET VALUE OF THE COMPANY? Graham stated in his later life that he believed the market was made up of two components. One is long-term-investment oriented, so that over time the market price of a company's stock would reflect its intrinsic value. The other component is like a casino: He believed that as a whole the casino side of the equation dominated, with people and institutions speculating on the impact that daily information would have on the value of the security.

Graham believed that it was this casino aspect that allowed the patient investor the opportunity to practice his craft. For while fear and greed dominated the floor of the casino, it offered the long-term investor the opportunity to buy companies at below their intrinsic value. Warren subscribes to the same theory, with one addition. He believes that the long-term-investment nature of the market will continually ratchet up the price of a company's stock if it can properly allocate capital and keep adding to the company's net worth.

Warren expanded the company by allocating the company's retained earnings to the purchase of whole and partial interests in businesses that have exceptional economics. As the net worth of the company grew, so did the market's valuation of the company, thus the rise in the price of the stock.

Another great example of this long-term market phenomenon is the Philip Morris Company. This is a major manufacturer of cigarettes that over the last twenty years has had a dark cloud hanging over its head in the form of hundreds of lawsuits filed by people with cancer blaming their illness on Philip Morris and its very profitable product.

But the company kept making more money and acquiring more and more businesses. Its net worth and per share earnings continued to grow. So with the advance in the company's net worth and per share earnings, the company's stock increased in price as well, even though it continued to trade at between eight and fourteen times earnings.

Even though Philip Morris was stigmatized by the market, the long-term phenomenon of market price matching the intrinsic value of a business managed to increase the price of the stock, giving its shareholders over the last ten years an annual compounding rate of return of approximately So remember, over the short term the market is manic-depressive, with irrational mood swings driving the prices of securities to foolish highs and insane lows.

It is the market's manic-depressive behavior that offers opportunity to the investor. For the wise investor knows that over the long term the market will adjust the stock's price to reflect the real value of the business. Warren is looking for a company that has a stock price that is responding to a real increase in the economic value of the company. He is not looking for a company that has a stock price that is increasing because of speculative pressure. One is a sure thing, the other is a bet at the race track.

Warren is looking to invest in the business that has excellent economics working in its favor, which produces monopoly like profits.

He has found that these excellent businesses usually have some kind of consumer monopoly, usually a brand-name product or service that consumers believe offers superior advantages over the competition. Warren discovered that simply being able to retain earnings free of the burden of having to spend them on maintaining current operations was not enough. The management of the business must have the ability to allocate retained earnings to new moneymaking ventures that also give high rates of return on invested capital.

If no new ventures are available, these excellent businesses engage in stock buybacks. Warren also found that an excellent business, as a rule, will be conservatively financed and will have the freedom to adjust the prices of its product or services with inflation. We now have an idea of what the beast looks like. In the next chapter we shall see what business fields it can be found hiding in. Where to Look for Excellent Businesses. Where do you find the excellent businesses that have created conceptual toll bridges?

There are basically three types of toll bridge businesses that produce excellent results: Let's examine each of these categories. Merchants like the local supermarket , as opposed to manufacturers like the Coca-Cola Company , make their profits by buying low and selling high. The merchant needs to pay as little for a product as possible and sell it for as much as possible.

His profit is the difference between what he paid for the product and what he sells it for. If there are several manufacturers of a product, a merchant can shift from one to the other, shopping for the lowest price. However, if there is a product that only one manufacturer sells, then the merchant has to pay the price the manufacturer is asking; this gives the pricing advantage to the manufacturer and not the merchant.

This means higher profit margins for the manufacturer. Note also that when a great number of merchants need a particular product and there is only one manufacturer, the price competition is shifted to the merchants. Thus, different merchants cut the price of the product to stimulate sales. But the manufacturer continues to charge all his stores the same price. The price competition between the different merchants destroys the merchants' profit margins and not the manufacturer's.

Companies that manufacture brand-name products that wear out fast or are used up quickly and that merchants have to carry to be in business are, in effect, a kind of toll bridge. The consumer wants a particular brand-name product; if the merchant wants to earn a profit, he has to supply the consumer with that product. The catch is that there is only one manufacturer, only one bridge, and if you want that brand-name product, you have to pay the toll to that manufacturer. Let's make a trip down to the local Kwik Shop or 7-Eleven.

As you stand at the door, can you predict what brand-name product it has to carry to be in business? Well, it has to carry Coca-Cola, Marlboro cigarettes, Skoal chewing tobacco, Hershey's chocolate.

Wrigley's chewing gum, and Doritos. Without these products the owner is losing sales and money. The manufacturers of all these productsthe Coca-Cola Company, the Philip Morris Company Marlboro cigarettes , US Tobacco Skoal chewing tobacco , Hershey Foods Hershey's chocolate , Wm. Company Wrigley's chewing gum , and the Pepsi-Cola Company maker Of Doritos all earn above-average rates of return on equity.

Name me eight brand-name products that every pharmacy has to carry. Crest toothpaste, Advil, Listerine, Coca-Cola, Marlboro cigarettes, Tampax tampons, Bic pens, and Gillette razor bladeswithout these products the drugstore merchant is going to lose sales. And the manufacturers of all these products earn high returns on equity. When you eat out at a restaurant, you don't order your coffee by brand name.

Nor do you order your hamburger and fries or BLT or shrimp fried rice by brand name. The company that sells the restaurant hamburger is not making above-average profit returns on equity, because nobody ever walks into a restaurant and asks for a hamburger ground up by Bob's Meats. But you order your Coca-Cola by brand name. And if you own a restaurant and you don't carry Coca-Cola, well, you just lost some sales. What brand-name products must most clothing stores sell? Fruit of the Loom or Hanes underwear and, of course, the ubiquitous Levi's.

Both earn their manufacturers high rates of return on equity. How about stores that sell running shoes? Does Nike strike a bell? Nike earns excellent returns on equity. How about the corner hardware store? WD and GE light bulbs. Both of these manufacturers earn, you guessed it, above-average returns on equity. Think about the prescription drugs behind the druggist's counter. We live in an age where an overcrowded planet is connected by thousands of daily international flights; new diseases can jump from one country to another in a matter of hours.

Throw in the fact that viruses can mutate into a new disease almost overnight, and it doesn't take a genius to see that these modern-day potion salesmen, the pharmaceutical companies, are going to have an ever-increasing demand for their lifesaving products. Products that people desperately need, protected by patents, mean that if you want to get well, you have to pay the toll. The gatekeeper, the druggist, has to carry the products or he is going to lose business. They are very profitable enterprises.

We should take special note of restaurant chains that have created brand-name products out of generic food. Restaurant chains, such as McDonald's, have taken the most ubiquitous of food, the hamburger, and turned it into a brand-name product.

The key to their success is quality, convenience, consistency, and affordability. Take a bite out of a McDonald's hamburger in Hong Kong and it tastes just like the one you bit into the month before in the good old U. McDonald's consistently earns above-average rates of return on equity. Advertising by manufacturers ensures that customers will demand the advertised products and that merchants can't substitute a cheaper product on which they can get a fatter profit margin.

The merchant becomes the gatekeeper to the toll bridge, with the manufacturer being guaranteed his profit. Since these products are consumed either on the spot or within a short period of time, the gatekeeper and the manufacturer can expect many profitable trips across the bridge.

To Warren the brand-name consumer product is the kind of toll bridge business that he is interested in owning. Long ago, the manufacturers of products reached their potential customers by having company salesmen call on customers directly. But with the advent of radio, television, newspapers, and a huge number of highly specialized magazines, manufacturers found that they could make their pitch directly to thousands of people with a single well-placed advertisement.

Manufacturers found that these new mediums of reaching the customer worked, which meant increased sales and profits.

Ultimately advertising became the battleground on which manufacturers competed with one another, with huge consumer corporations spending hundreds of millions of dollars a year on getting their "buy our product" message to the potential customer. After a while these companies found there was no turning back; manufacturers had to advertise or they ran the risk that some competitor would sweep in and take over their coveted niche in the marketplace.

Warren found that advertising created a conceptual bridge between the potential consumer and the manufacturer. In order for a manufacturer to create a demand for its product, it must advertise. Call it an advertising toll bridge. And this advertising toll bridge profits the advertising agencies, magazine publishers, newspapers, and telecommunications networks of the world. When there were only three TV major networks, each one made a great deal of money.

Seeing this, Warren invested heavily in Capital Cities and then ABC. Now that there are sixty-seven channels to choose from, the networks don't do as well.

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They still make a ton of money, just not as much as when there were only three network toll bridges crossing the river. The same can be said of the newspaper business. A lone newspaper in a good-size town can make excellent returns, but add a competitor and neither will do very well. This is what Warren experienced with the Buffalo Evening News. When there was a competitor in town, the paper was at best an average business.

But since the competitor went out of business, the Buffalo Evening News has been getting spectacular results. Warren has found that if there is only one newspaper toll bridge in town, it can jack its advertising rates to the moon and still not lose customers.

Where else are the manufacturers and merchants going to cross the river to reach the consumer by print media? Advertising agencies that function on a world scale also enjoy high returns on equity by being in a unique position to profit from the huge consumer multinational companies that sell their products the world over.

If one of these multinational companies wants to launch an advertising campaign, it has to use an advertising agency like Interpublic, the second-largest advertising agency in the world. Interpublic becomes the toll bridge to the consumer that the multinational manufacturer must cross.

Not products, but services. And the services provided can be performed by nonunion workers, often with limited skills, who are hired on an as-needed basis. This odd segment of the business world includes such companies as Service Master, which provides pest control, professional cleaning, maid service, and lawn care: Rollins, which runs Orkin, the world's largest pest and termite control service, and also provides security services to homes and businesses.

All of these companies earn high rates of return on equity. This segment of Warren's toll bridge world also includes the credit card companies that he has invested in, such as American Express and Dean Witter Discover. Every time that you use one of these company's cards, it charges the merchant a fee, or toll.

If you fail to pay your credit card bill within your grace period they get to charge you a fee as well.

Millions of little tolls taxed to each transaction add up. Also, these strange credit card toll bridges don't need huge plants and equipment that suck up capital. The key to these kinds of companies is that they provide necessary services but require little in the way of capital expenditures or a highly paid, educated workforce. Additionally, there is no such thing as product obsolescence. Once the management and infrastructure are in place, the company can hire and fire employees as the work demand dictates.

When there is no work, you don't have to pay him. Also, no one has to spend money and energy on upgrading or developing new products. The money these companies make goes directly into their pockets and can be spent on expanding operations, paying out dividends, or buying back stock.

As long as the locusts keeping coming, the termites keep eating, the thieves keep thieving, shoppers keep using credit cards, and governments keep taxing us, these companies will make money. Lots of it, for a long time. This mental process is much better than thumbing though endless financial magazines and guides searching for the elusive company of your dreams.

The products you will come up with will lead you to the companies that are sitting on consumer jackpots of gold and getting high returns on equity and superior results for their owners.

So get a pen and paper out and start guessing. Other companies of interest will be those that are uniquely situated to profit from providing advertising services to businesses, like the only newspaper in town. One of the great keys to Warren's success is that he figured out a method for determining whether he was dealing with one of those rare excellent businesses that would allow him to reap a bountiful harvest year after year or with a mediocre business whose inherent economics would cement him to mediocre results.

To facilitate his thinking, Warren divided the business world into two separate categories: He discovered that the underlying economics of consumer monopolies were the most profitable for their owners and that as a group they tended to outperform the market as a whole.

But first things first. Let us look at the commodity-type business and the subtleties that make it an undesirable investment when compared to the enterprise that has a consumer monopoly working in its favor. THE COMMODITY TYPE BUSINESS. When we say commodity-type business we mean a business sells a product whose price is the single most important motivating factor in the consumer's buy decision.

The most simple any obvious commodity-type businesses that we deal with in our daily lives are. All these companies sell a commodity for which there is considerable competition in the marketplace. The price is the single most important motivating factor for the consumer making a buy decision.

One buys gasoline on the basis of price, not on the basis of brand, even though the oil companies would like us to believe that one brand is better than the other. Price is the dictating factor. The same goes for such goods as concrete, lumber, bricks. It really doesn't matter where the corn you buy in the store comes from, as long as it is corn and it tastes like corn. The intense level of competition leads to very competitive markets and, in the process, very low profit margins.

In commodity-type businesses the low-cost provider wins. This is because the low-cost provider has a greater freedom to set prices. Costs are lower, therefore profits margins are higher. It's a simple concept but it has complicated implications, because to be the low-cost producer usually means that the company must constantly make manufacturing improvements to keep the business competitive.

This requires additional capital expenditures, which tend to eat up retained earnings, which could have been spent on new-product development or acquiring new enterprises, which would increase the value of the company. The scenario usually works like this: Company A makes improvements in its manufacturing process, which lowers its cost f production, which increases its profit margins.

Company A then lowers the price of its product in an attempt to take a greater market share from Companies B, C, and D.

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Companies B, C, and D start to lose business to Company A and respond by making the same improvements to the manufacturing process as Company A. Companies B, C, and D then lower their prices to compete with Company A and in the process destroy any increase in Company A's profit margins that the improvements in the manufacturing process created. And then the vicious cycle repeats itself. There are occasions on which demand for a service or product outstrips supply.

When Hurricane Andrew smashed into Florida and destroyed thousands of homes, the cost of sheet plywood shot through the roof At times like this, all the producers and sellers make substantial profits. But increase in demand is usually met with increase in supply. And when demand slackens, the excess increase in supply drives prices and profit margins down again.

Additionally, a commodity-type business is entirely dependent upon the quality and intelligence of management to create a profitable enterprise. If management lacks foresight or engages in wasting the company's precious assets by allocating resources unwisely, the business could lose its advantage as the low-cost producer and face the possibility of competitive attack and financial ruin.

From an investment standpoint, of Warren's two business models, commodity-type businesses offer the least for future growth of shareholder value. First, these companies' profits are kept low because of price competition , so the money just isn't there to expand the business or to invest in new and more profitable business ventures.

And second, even if they did manage to make some money, this capital is usually spent upgrading plant and equipment to keep abreast of the competition. Commodity-type businesses sometimes try to create product distinction by bombarding the buyer with advertising in which manufacturers attempt to get the buyer to believe their product is better than the competition's.

In some instances there are considerable product modifications to keep ahead of the competition. The problem, however, is that no matter what is done to a commodity-type product, if the choice the consumer makes is motivated by price alone, the company that is the low-cost producer will be the winner, and the rest end up struggling. As an example of the poor investment qualities of the commodity-type business, Warren loves to use Burlington Industries, which manufactures textiles, a commodity-type product.

The majority of the capital expenditures were for cost improvements and expansion of operations. It was also getting far lower returns oil sales and equity than it did in The managers at Burlington are some of the most able in the textile industry, but the industry is the problem.

Poor economics, which developed from excess competition, resulted in substantial overcapacity in the entire textile industry. Substantial overcapacity means price competition, which means lower profit margins, which means lower profits, which means a poorly performing stock and disappointed shareholders. Warren is fond of saying that when management with an excellent reputation meets a business with a poor reputation, it is usually the business's reputation that remains intact.

Identifying a commodity-type business is not that difficult; they usually are selling something that a lot of other businesses are selling. Characteristics include low profit margins, low returns on equity, difficulty with brand-name loyalty, the presence of multiple producers, the existence of substantial excess production capacity in the industry, erratic profits, and profitability almost entirely dependent upon management's abilities to efficiently utilize tangible assets. The basic characteristics of a commodity business are.

Low profit margins are the result of competitive pricing-one company lowering the price of its products to compete with another company. Low returns on equity are a good indication that the company that you are looking at is a commodity type. If the brand name of the product you just bought doesn't mean a lot, you can bet you are dealing with a commodity-type business.

Go into any auto supply store and you will find seven or eight different brands of oil, all of them selling for about the same price.

Multiple producers breed competition, and competition breeds lower prices, and lower prices breed lower profit margins and lower profit margins breed lower earnings for the shareholders.

Anytime you have substantial excess production capacity in an industry, no one can really profit from an increase in demand until the excess production capacity is used up. Then and only then can prices start to rise. However, when prices rise, management will get the urge to grow. Grand visions of huge industrial empires may dance in management's heads.

And with pockets full of shareholder's riches derived from the increase in demand and prices, management will set forth on the ultimate in grand illusions. They will expand production and in rhe process create even more production capacity. The problem is that the guys down the street who are the competition also have the same idea. Soon everybody expands production and we are back in the position of overcapacity. Overcapacity means price wars, and price wars mean lower profit margins and profits.

And then everything starts all over again. A real good sign that you are dealing with a commodity-type business is that the profits are wildly erratic. A survey of a company's per share earnings for the last seven to ten years will usually show any boom-or-bust patterns, which are endemic to the commodity-type business.

If yearly per share earnings of the business in question look like this then you might suspect that it is a commodity-type business. Anytime profitability of a company is largely dependent upon the business's ability to efficiently utilize its tangible assets, such as plant and equipment.

Remember, if price is the single most important motivating factor in the purchase of a product, then you are most likely dealing with a commodity-type business. As such, the company probably will present you at best with only average results over the long term. The mathematical tools that you will need in order to evaluate whether a potential investment makes business sense at a given price are for the most part fairly simple.

Before you start tapping away on your calculator, you must have established the nature of the company and answered the key questions necessary to determine the predictability of the company's future earnings. Then you must decide whether the company is an excellent business that benefits from a consumer monopoly or a commodity-type business that is doomed to average results. You must also determine if the company is managed by people who are honest and competent and who function with their shareholders' best interests in mind.

Although, as we know, Warren believes that it is hard to damage a great consumer monopoly by poor management, poor management can make it difficult for the investor to profit from the economics of a great consumer monopoly.

As we observed, Coca-Cola in the seventies is a prime example of this phenomenon. Coca-Cola has a fantastic consumer monopoly but was run in the seventies by management that seemed uncertain about how to increase the per share value of the business. As a result, the company sat dormant, awaiting more enlightened management.

It arrived with the appointment of Roberto Goizueta as Coca-Cola's president in Goizueta immediately picked up the ball and ran for touchdown after touchdown, which produced an increase in Coca-Cola's per share earnings, which caused the price of the stock to shoot up like rockets.

You, the investor, must also figure out if the company's management has the ability to effectively allocate capital in a profitable fashion. This can be determined with the help of a number of calculations. After the economic nature of the business is determined, you can use several other calculations, explained in detail on the pages that follow, to determine whether the stock is selling at an attractive price. Test 1, to Determine at a Glance the Predictability of Earnings. This is the simplest test you can perform and it is probably the most basic.

Although every security analyst performs it the first time his or her eyes scan a Moody's or Value Line , few will acknowledge it as a calculation. But it is, because it is the first place you must start the process of statistical analysis.

To put it simply, you merely look at and compare the reported per share earnings for a number of years. Are they consistent or inconsistent? Do earnings trend upward, or do they jet up and down like a roller coaster? The investment survey services, such as Moody's and Value Line, make this comparison of yearly figures very easy by providing you with a list of earnings dating back a number of years.

Does the earnings picture of your company look like Company I, or Company II? Company I has more predictable earnings than Company II. You don't need to be a genius to see that.

A look at the earnings of Company II indicates that they are all over the place, with no trend being apparent. You should have picked Company I. Even though all you know about the company is its ten years of earnings, you know that they 1 are strong and 2 have an upward trend. Your next question should be, What were the economic dynamics that created this situation? Company II, from a Grahamian point of view, may have some investment merit.

From a Buffett point of view, the lack of strong earnings indicates that Company II's future earnings would be impossible to predict with any degree of comfort. Thus, Graham may have considered for investment both Company I and Company II. But Warren at first glance would have considered only Company I. We've mentioned that Graham used to say that you didn't need to know someone's weight to know he was fat.

The same holds true in reviewing the earnings history of a company. The first thing you should do when investigating the earnings history of a company is gather together the per share earnings figures for the last seven to ten years and see if they present a stable or unstable picture.

There will be lots of black-and-white examples, but also quite a few that fall into a gray area. If something seems fishy, don't be afraid to move on. But knowing what you know now, if something smells interesting, don't be afraid to go on and dig a little deeper. Let's apply this test to Warren's most recent purchase of Coca-Cola common stock.

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All Coca-Cola examples have been adjusted to reflect all stock splits through When Warren first took a look at Coca-Cola's yearly per share earnings, this was what he saw: It's easy to see that Coca-Cola's per share earnings for the period of to are consistent, strong, and growing at a steady rate.

Coca-Cola in passes Warren's first test. Test 2, to Determine Your Initial Rate of Return. This calculation tells you the initial rate of return that you can expect at a particular price. This is where Warren and Graham initially derive the theory that the price you pay will determine your rate of return.

The higher the price, the lower the rate of return. The lower the price, the higher the rate of return. Test 3, to Determine the Per Share Growth Rate.

Management's ability to grow the per share earnings of a company is key to growth of the shareholders' value in the company. In order to get per share earnings to grow, the company must employ its retained earnings in a manner that will generate more earnings per share.

The increase in per share earnings will, over a period of time, increase the market valuation for the company's stock. A really fast and easy mathematical method of checking the company's ability to increase per share earnings is to figure the annual compounded rate of growth of the company's per share earnings for the last ten years and the last five years.

This will tell you the annual compounding rate of growth of the earnings over the long and short run. We use the two numbers to allow us to see the true long-term nature of the company and to determine whether management's near-term performance has been in line with the long term. Let's get on with some examples and then we can do some in depth analysis. We'll go back and look at the yearly per share earnings of General Foods: Earnings for General Foods, The number of years is ten.

Five is the number of years. These two numbers tell you several different things. The first is that the company has had a higher rate of earnings growth in the last five years, to , than it did in the ten-year period from to The question you need to ask is, Why the change?

And what effect will past economics have on our ability to predict the company's future earnings? What were the business economics that caused this change? Was General Foods buying up its own stock, or was it finding new business ventures to be profitably involved in? Here is an application of the per share earnings growth test to Warren's purchase of , shares of Coca-Cola stock in A check of Coca-Cola's per share earnings indicates the following: Coca-Cola's per share earnings grew at an annual rate of So, if you have a Texas Instruments BA Solar calculator, you would go to the financial mode.

And this rate of return would expand because Coca-Cola's per share earnings were growing at an annual compounding rate of Determining the Value of a Company Relative to Government Bonds.

A way of establishing the value of a company relative to government bonds is to divide the current per share earnings by the current rate of return for government bonds. This allows you to quickly compare them. This means that you could have bought the stock at a price that was below its relative value to the return being paid of government bonds in This is where you use the annual per share earnings growth rate.

Thus you can ask yourself this question: Many analysts believe that if you divide the per share earning by the current rate of return on government bonds you end up with the intrinsic value of the company. But all you end up with is the value of the company relative to what the return is on government bonds.

The same thing applies to the theory that the intrinsic value of a business is its future earnings discounted to present value. It you use the rate of return on government bonds to determine the discount rate, what you end up with is a discounted present value relative to the rate of return on government bonds. Also, remember that the return on government bonds is a pre-income-tax return and the net earnings figure of a corporation is an after-corporate-tax return.

So, comparing the two without taking this into account is fraught with folly. Still, it is a method that has a place in our box of tools. Understanding Warren's Preference for Companies with High Rates of Return on Equity. To understand Warren's preference for businesses that have a high return on equity, you must remember that Warren views some common stocks as a sort of bond.

But since a business's earnings are given to fluctuation, the return on equity is not a fixed figure as it is with bonds.

The return on equity will fluctuate as the relationship of equity to net earnings changes. As we know, shareholders' equity is defined as a company's total assets less the company's total liabilities. Let's say you own a business; we will call it Company A.

Now imagine that you own another business; call it Company B. Both companies have exactly the same capital structure, yet Company A is four times as profitable as Company B.

That's the easy part of this trick. Of course the better company is Company A. Now let's say that the management at both Company A and Company B are really good at what they do. What do you do? Of course it is. Company A is making you very rich. So you let it keep the money.

The picture in not nearly as clear as it is with Company A. Let me ask you this: If I told you that you could take Company B's dividend and reinvest it in Company A, would that help you make up your mind? Of course it would. By now you can start to see why companies that earn high returns on shareholders' equity are big on Warren's list. But there are a few more twists to the wealth-creating power that high returns on equity will produce.

Let's pretend that you don't own either Company A or Company B. But you are in the market to buy a business. So you approach the owners of Company A and Company B and tell them that you interested in buying their business and ask them if they are interested in selling. Now, Warren believes that all rates of return ultimately compete with the rate of return that is paid on government bonds.

He believes that the government's power to tax ensures the bonds safety, and investors are very aware of that. He believes that this competition of rates is one of the main reasons that the stock market goes down when interest rates go up and why the stock market goes up when interest rates go down. Keeping this in mind, the owners of Companies A and B compare what they could earn by selling their businesses and putting their capital into government bonds.

This means that they could forget about the hassles of owning a business and still earn the same amount of money. One of the keys to understanding Warren is that he is not very interested in what a company will be earning next year.

What he is interested in is what the company will be earning in ten years.

While Wall Street is focusing on next year, Warren realizes that to let compounding work its wonders he has to focus on predicting the future. That is why companies that have consumer monopolies and are earning high rates of return on shareholder equity are so very important to him. Warren would find Company A far more enticing than Company B. And so, every year the shareholders' equity pot is going to grow. It is the growing equity pot and the earnings that go with it that Warren is interested in.

Let me show you. Now take a moment and look at the equity and earnings projections for Company A found on the chart that follows. Remember that Warren is after the highest compounding rate of return possible.

Now let's compare this to Company B. Take a moment and study the equity and earnings projections for Company B found below. In fact, Company A may be worth a whole lot more. The question Warren must address is, How much more?

Let's figure it out. And let's say you sold it at the beginning of Year 11, which means you effectively held the investment for ten years, for A compounding annual rate of return of The secret that Warren has figured out is that excellent businesses that benefit from a consumer monopoly, that can consistently earn high rates of return on shareholders' equity, are often bargain buys even at what seem to be very high price-to-earnings ratios. I know that some of you are thinking that the above example is just a hypothetical and that this kind of thing never happens in real life, and that the market is efficient and never offers this kind of return.

In Coca-Cola passed Warren's requirement that a company show consistently above-average annual rates of return on equity. Determining the Projected Annual Compounding Rate of Return, Part I. Now, before we jump into projecting the annual compounding rate of return we expect a potential investment to produce, you should understand that all these mathematical equations serve merely to give you a better picture of the economic nature of the beast. Each of the calculations will tell you a little something different.

Yet each describes the same business and each gives you another perspective of the business's earning power. Earning power is the key to predictability, and predicting future results is the job of the security analyst.

Warren has defined the intrinsic value of a business as the sum of all the business's future earnings discounted to present value, using government bonds as the appropriate discount rate. Warren cites The Theory of lnvestment Value by John Burr Williams Harvard University Press, as his source for this definition. John Burr Williams, on the other hand, cites Robert F. Wiese, "Investing for Future Values" Barron's , September 8, , p. Wiese stated that "the proper price of any security, whether stock or bond, is the sum of all future income payments discounted at the current rate of interest in order to arrive at the present value.

Warren treats it as future earnings, regardless of whether or not they are paid out. We all know that projecting a business's earnings for the next one hundred years is impossible. Sure, you could try, but the realities of the world dictate that some change will occur and destroy or change the economics of the business in question.

Just look at the television industry. It was hardly a bump on the economic landscape in the s. In the s and s it was a fantastic business for anyone involved. After all, there were only three channels. So great was the networks' monopoly position that Warren said in the early eighties that if he had to invest in just one company and then go away to a deserted island for ten years, it would be Capital Cities. Quite a strong vote of confidence.

But by Warren was of the opinion that the television business was no longer what it used to be. Dozens of channels had born started up, all competing for ad revenue. Absolutely unsinkable businesses are hard to find.

Coca-Cola may be one of the few. History tells us that even if your name is Medici, Krupp, Rothschild, Winchester, or Rockefeller, the wheels of commerce may not always turn in your favor. The monopoly that once was enjoyed, like that held by the early television networks, can vanish almost overnight due to a change in technology or the hands of government regulators.

The Medici family of Italy spent the last five hundred years, trying to get over the fact that the Dutch sailed around the horn of Africa and destroyed Venice's monopoly on trade with the Orient.

Things change, and though commerce has elements of repetition, fortune favors the brave, and the brave constantly test the fertile waters of commerce, looking for new ways of making a buck. Keeping this in mind, you would invite sheer folly by thinking, you had a chance in a million of projecting a company's earning, fifty to one hundred years and then discounting them back to present value.

There are just too many variables. It may be true in theorybut in reality, summing up all a company's future earnings and discounting them to present value creates impossible number combinations, especially if you are factoring a constant rate of growth.

It is of interest that Graham also noted the insane valuations that discounting a company's future earnings to present value often creates, especially when the earnings are constantly growing. Some analysts try to solve this problem by dividing the future earnings into two different periods. The first period is assigned the high growth rate and the second period is assigned a lower growth rate. The problem here, as Williams discussed, is that anytime you have a rate of earnings growth that is less than the rate of interest used in the discounting equation, the stock will end up having a value of zero, even though growth continues on without limit.

See The Theory of Investment Value , p. An additional problem is the discount rate chosen. If you choose the rate of return being paid on government bonds, you are in effect discounting the business's future earnings at a rate of return that is relative to the government bond rate of return. Also, if the rate of interest changes, your evaluation changes as well. The higher the interest rate, the lower the valuation.

The lower the interest rate, the higher the valuation. One other problem with using government bonds as a discount rate is that their yield is quoted in pretax terms.

What Warren does is to project the per share equity value of the company in question for a period of, say, five to ten years. This is done by using historical trends for the return on equity less the dividend payout rate. Warren figures out approximately what the equity value of the company will be at the future date, say, in ten years, and then he multiplies the per share equity value by the projected future rate of return on equity ten years out, which gives him the projected future per share earnings of the company.

Using the projected per share earnings of the company, he is then able to project a future trading value for the company's stock. Using the price he paid for the stock as the present value, he can then calculate his estimated annual compounding rate of return.

Warren then compares this projected annual compounding rate of return to other rates of return being offered in the market and to what his needs are to keep ahead of inflation. Let me show you, using Berkshire Hathaway as an example. For the period from to , Berkshire's rate of return for stockholders' equity was If you want to project the company's equity per share figure for , all you have to do is get out the old and trusted Texas Instruments BA Solar financial calculator and switch to the financial mode and perform a future value calculation.

First of all, you need to ask yourself how much return you are looking to get. First, clear your calculator of the last calculation. Hit the compute button CPT and the present value button PV. By Berkshire ended up growing its per share equity value at a compounding annual rate of approximately With a compounding annual rate of return of approximately What would your annual rate of return be if you held the stock for ten years?

You can make a market price adjustment to this calculation by figuring that over the last thirty-two years Berkshire has traded in the market for anywhere from approximately one times its per share equity value to double its per share equity value.

So, depending on the market value for Berkshire, you can project a before-tax annual compounding rate of return of somewhere between Any hope of doing better than that is wishful thinking. Determining the Projected Annual Compounding Rate of Return, Part II. In the preceding chapter we learned how to calculate the future value of Berkshire Hathaway by projecting its future per share equity value.

We also saw that once a future value is determined, it is possible to project the annual compounding rate of return the investment will produce. In this chapter we will project the future per share earnings of a company and then determine its future market price. We will then use the results of these calculations to project the annual compounding rate of return that the investment in question will produce.

I think it would be very instructive at this point if we explored a real-life example of Warren's decision making. In the following we shall explore in depth the financial reasoning that led Warren to take his initial position in the Coca-Cola Company. This is a very important chapter because it brings to light several key concepts that have escaped many students of Warren's methods. All the historical figures given for Coca-Cola have been adjusted to reflect stock splits through Coca-Cola, in , had shareholders' equity of He also figured that this This portion of the yield is the after-corporate-tax portion and is subject to no more state or federal taxes.

This portion of the return is subject to personal or corporate taxes for dividends. One is a The other is a Now, if we assume that Coca-Cola can maintain this Then hit the CPT key and future value key FV. If you want to project the per share earnings , all you have to do is multiply the per share equity value by Let's do the calculations and project out the per share equity value and per share earnings of Coca-Cola for twelve years, beginning in and ending in Projections usually aren't worth the paper they are written on.

Most financial analysts are willing to project earnings only for a year or two in advance, and then they give you an overview of the company and pronounce it a buy. But Graham felt that the real role of the analyst was to ascertain the earning power of the business and make a long-term projection of what the company was capable of earning Security Analysis , , p. In the following table we have projected per share earnings for twelve years. In most situations this would be an act of insanity.

However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders' equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made.

Projections for to Year EQUITY VALUE PER SHARE EARNINGS DIVIDENDS PAID OUT RETAINED. Since we have projected Coca-Cola's per share earnings from the year , we can find out if our analysis has any validity to it. To do this we can compare our projected per share earnings for to against the actual results reported by Coca-Cola for to If Coca-Cola can maintain a The further forward you go, the greater chance for variation in actual results versus projected results.

This is not a game of absolutes. Per Share Earnings Projections to Actual Results. Not bad for a day's work. When in doubt, choose the middle road. This will give you the annual compounding rate of return, which in this case will be either Thus, Warren could project an annual compounding rate of return of between We can adjust these numbers to reflect the dividends Coca-Cola paid out and any taxes Warren would have to pay if he sold the stock in the year This equates to an after-tax annual compounding rate of return of Thus, in the year , if Coca-Cola is trading at fifteen times earnings and Warren elects to sell his stock, his annual compounding rate of return after taxes will be Even if Coca-Cola's stock is trading at only nine times earnings in the year , Warren can still project an after-tax annual compounding rate of return of Now, imagine if I came to you and said that I wanted to sell to you, at par value, a non-callable twelve-year Coca-Cola bond that paid a tax-free, fixed annual rate of return of Mouth starting to water yet?

What would you do? I'd mortgage the farm, house, and kids, and buy all I could. But I can tell you that the likelihood of that ever happening is nil.

However, back in , you could have bought the stock in the Coca-Cola company and essentially got a tax-free equivalent annual compounding rate of return of between As luck would have it, the stock market started valuing Coca-Cola stock in and at historically high price-to-earnings ratios of 40 and better.

This has enabled Warren to show a higher annual compounding rate of return than is projected here for the period of between and What creates all this wealth is Coca-Cola's ability to take its retained earnings and earn a This effectively compounds the retained earnings by adding them to the base sum from which they were created. And that, folks, is how it works.

Let's say also that he wants to hold his purchase only until the year What would his expected rate of return be if he sold his purchase of Coca-Cola stock in ? Thus Warren could project in that if he held his investment to , it would produce for him an after-tax annual compounding rate of return of An after-tax compounding annual rate of return of Remember that if it was a government bond it would have to have a before-tax annual rate of return of See any government bonds paying a How about corporate bonds?

Now do you see why Warren keeps going to the soda fountain and ordering more Coca-Cola? Things do go better with Coke, including your money. Warren has more than one way of looking at an investment situation. Let's see how this works with the Coca-Cola situation. You might be wondering where the coupon concept comes from.

Bonds used to come with dozens of coupons attached to them. You'd clip a coupon and send it to the company that issued the bond, and they would send you the fixed rate of interest the bond had earned for a particular period of time. That way the company didn't have to keep track of who owned the bond. Today, bonds are registered with the company that issued them and a bondholder gets the interest checks in the mail without doing anything. Now, remember what we said earlier: This equates to Coca-Cola in earning a Now, an initial rate of return of 6.

But Warren was projecting that Coca-Cola's per share earnings would continue to grow and in the process cause an annual increase in his rate of return. Let's look more closely. We can explain Coca-Cola's economics from several vantage points, but the key is the return on equity and retained earnings.

At the beginning of , Warren's total investment in Coca-Cola is projected to be: Now, if Coca-Cola can maintain a Warren will be earning 6. Projected Per Share Return on Invested and Retained Capital for Rate of return on total capital invested for The same analysis can be run for as well. Total Per Share Investment in Coca-Cola at the Beginning of This equates to a 8.

I'm sure you noticed the increasing rate of return, but what I really want you to see here is that Warren's original investment in Coca-Cola is fixed at a rate of return of 6.