Over the years Warren Buffett has realized that a company with competitive advantage has earnings that are so predictable that its common stock “equity” is really a kind of “bond” with a variable coupon. He calls these equity bonds. (by Marry Buffett)
Obv, you all know what bonds are, suppose you buy INR 100 worth bond for 10 years and it has a coupon of 10%, it will pay you INR 10 each year and at the end of 10 year you get back your INR 100.
Rate of Return - Equity Bond
Equity Bond - The company’s net profits in any given year. If the company stock has a per share book value of INR 100 a share and has annual after tax earnings of 8 a share, Warren would argue that the equity bond is producing an annual after tax return of 8%.
If the company has been growing its net earnings at a historical annual rate of 10%(Growth), and its per share book value is 100, initial rate of return of 8 or 8% (8 / 100 = 8%), and that initial rate of return is going to grow at a projected annual rate of return of 10%. As times goes on, the underlying return on equity bond will increase.
Thus, the equity bond becomes an “expanding equity bond”.
Now, lets call the company as Warren Equity Bond its per share book value is INR 100 a share, and it has net earnings of INR 8 a share or 8% after tax.
For any great business, there is a premium to pay, that means,
Stock Price is higher than the per share book value. If that’s the case, the returns will be lower. For example, Warren Equity Bond is at INR 150 and the per share value is at INR 100,
We are spending 150 instead of 100 (returns drops down to 8% to 5.3%)
However, ten years from now, INR 8 a share, that we are earning now, growing 10% a year, will be theory grow to INR 20.75 a share after 10 years, which gives us approx after tax return of 13.8% on our INR 150 per share investment (20.75/150=13.8%).
Similarly Warren bought Coke in 1988, its book value was at $1.07 a share and priced at $5.22 a share, and net earnings of $0.36 a share. Initital rate of return (0.36/5.22=0.68) which is 6.8%
Coke is doing $3.85 a share and trading at $65 a share in 2011. Which was 1145% return for him.
Comes out to be 11.59% for 23 years.
Everything was taken from a book written by Marry Buffett. Please comment and lets discuss more in deeper level.