- Owner earnings (net cash flow) of Coca-Cola = $828 million.
- Risk free rate of 30 year US Treasury Bond = 9% yield.

__Discounted value of Coca-Cola’s current owner earnings.__If Coca-Cola’s 1988 owner earnings were discounted by 9% (Buffett does not add an equity risk premium to the discount rate):

- the
**value of Coca-Cola**would have been $828m/9% =**$9.2 billion.**

$9.2 billion represents the discounted value of Coca-Cola’s current owner earnings.

__Was Buffett paying too much for Coca-Cola?__

When Buffett purchased Coca-Cola, the** market value** of the company was** $14.8 billion**, indicating that Buffett might have overpaid for the company.

Because the market was willing to pay a price for Coca-Cola that was__ 60% higher__ than $9.2 billion, it indicated that buyers perceived part of the value of Coca Cola to be its future growth opportunities.

People asked, “Where is the value in Coke?”

The company’s price was

– 15x earnings (30% premium to the market average), and,

– 12x cash flow (50% premium to the market average).

__Where is the value in Coke? Its net cash flows discounted at an appropriate interest rate.__Buffett first purchased Coca-Cola in 1988.

Buffett paid 5x book value for a company with a 6.6% earning yield.

The company was earning a** 31% ROE** while employing

**relatively little in capital investment.**The __value of Coca-Cola__, like any other company, is determined by the net cash flows expected to occur over the life of the business, discounted at an appropriate interest rate.

When a company is able to grow owner earnings ** without the need for additional capital,** it is appropriate to discount owner earnings by

__the difference between the risk-free rate of return (k) and the expected growth (g) of owner earnings, that is (k-g).__

__Using a two-stage discount model__

Analyzing Coca-Cola, we find that owner earnings from 1981 through 1988** grew at 17.8% annual rate** – faster than the risk-free rate of return.

When this occurs, analysts use a** two-stage discount model. **

- This model is a way of calculating future earnings when a company has
, and__extraordinary growth for a limited number of years__ - then a period of
**constant growth at a slower rate.**

We use this two-stage process to calculate the 1988 present value of the company’s future cash flows.

In 1988, Coca-Cola’s owner earnings were $828 million.

If we assume that Coca-Cola would be able to grow owner earnings at 15% per year for the next 10 years (a reasonable assumption, since that rate is lower than the company’s previous seven-year average), by year 10, owner earnings will equal $3.349 billion.

Let us further assume that starting in year 11, growth rate will slow to 5% a year. Using a discount rate of 9% (the long term bond rate at the time), we can calculate that the intrinsic value of Coca-Cola in 1988 was** $48.3777 billion. ****(see Appendix A below for the detailed calculations.)**

__Using different growth-rate assumptions__

We can repeat this exercise using different growth-rate assumptions.

- If we assume that Coca-Cola can grow owner earnings at
the present value of the company discounted at 9% would be__12% for 10 years followed by 5% growth,__**$38.163 billion.** - At
the value of Coca-Cola would be**10% growth for 10 years and 5 % thereafter,****$32.497 billion.** - And if we
__assume only 5% throughout, the company__would still be worth**at least $20.7 billion**[$828 million divided by (9% – 5%)].

__Market price has nothing to do with value__

The stock market’s value of Coca-Cola in 1988 and 1989, during Buffett’s purchase period, averaged $15.1 billion.

But by Buffett’s estimation, the intrinsic value of Coca-Cola was anywhere from

- $20.7 billion (assuming 5% growth in owner earnings),
- $32.4 billion (assuming 10% growth),
- $38.1 billion (assuming 12% growth),
- $48.3 billion (assuming 15% growth).

So Buffett’s ** margin of safety** – the discount to intrinsic value – could be as

__low as a conservative 27% or as high as 70%.____“Value” investors using P/E, P/B and P/CF considered Coca-Cola overvalued and missed purchasing it.__

“Value” investors observed the same Coca-Cola that Buffett purchased and because **its price to earnings, price to book, and price to cash flow were all so high,** considered Coca-Cola **overvalued.**===========

__Appendix A: __

__The Coca-Cola Company Discounted Owner Earnings Using a Two-Stage “Dividend” Discount Model (first stage is 10 years)__

__First stage:__

Owner Earnings in 1988 $828 m

Growth rate 15% for next 10 years

Discount factor 9%

Sum of present value of owner earnings =** $11,248 **

(Year 1 to 10)

__Second stage:__

Residual Value or Terminal Value

Owner earnings in year 10 $3,349

Growth rate (g) 5%

Owner earnings in year 11 $3,516

Capitalization rate (k-g) 4%

Value at end of year 10 $87,900

Discount factor at end of year 10 0.4224

Present Value of Residual = ** $37,129**__Intrinsic Value__

Intrinsic Value of Company = ** $48,377**

__Notes: __

Assumed first-stage growth rate = 15%

Assumed second-stage growth rate = 5%

k = discount rate = 9%

Dollar amounts are in millions.__Descriptive step-by-step approach to the above DCF:__

Th**e **first stage applies 15% annual growth for 10 years.

In year one, 1989, owner earnings would equal $952 million; by year ten, they will be $3,349 billion.

Starting with year eleven, growth will slow to 5% per year, the second stage.

In year eleven, owner earnings will equal $3,516 billion ($3,349 billion x 5% + $3,349 billion).

Now we can subtract this 5% growth rate from the risk-free rate of return (9%) and reach a capitalization rate of 4%.

The discounted value of a company with $3,516 billion in owner earnings capitalized at 4% is $87.9 billion.

Since this value, $87.9 billion, is the discounted value of Coca-Cola-s owner earnings in year eleven, we next have to discount this future value by the discount factor at the end of year ten 1/(1 + 0.09)^10 = 0.4224.

The present value of the residual value of Coca-Cola in year ten is $37.129 billion.

The value of Coca-Cola then equals its residual value ($37.129 billion) plus the sum of the present value of cash flows during this period ($11.248 billion), for a total of $48.377 billion.

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