114 THE WARREN BUFFETT WAY
securities to justify the unjustif iable and thereby sell what should be un-
salable. When earnings look inadequate to service debt of a junk bond
or justify a foolish stock price, how convenient it becomes to focus on
cash f low.”^5 But you cannot focus on cash f low, Buffett cautions, un-
less you are willing to subtract the necessary capital expenditures.
Instead of cash f low, Buffett prefers to use what he calls “owner
earnings”—a company’s net income plus depreciation, depletion, and
amortization, less the amount of capital expenditures and any addi-
tional working capital that might be needed. It is not a mathematically
precise measure, Buffett admits, for the simple reason that calculating
future capital expenditures often requires rough estimates. Still, quot-
ing Keynes, he says, “I would rather be vaguely right than precisely
wrong.”
Coca-Cola
In 1973, “owner earnings” (net income plus depreciation minus capital
expenditures) were $152 million. By 1980, owner earnings were $262
million, an 8 percent annual compounded growth rate. Then from 1981
through 1988, owner earnings grew from $262 million to $828 million,
a 17.8 percent average annual compounded growth rate (see Figure 7.3).
The growth in owner earnings is ref lected in the share price of
Coca-Cola. In the ten-year period from 1973 to 1982, the total return
of Coca-Cola grew at a 6.3 percent average annual rate. Over the next
ten years, from 1983 to 1992, the total return grew at an average an-
nual rate of 31.1 percent.
PROFIT MARGINS
Like Philip Fisher, Buffett is aware that great businesses make lousy in-
vestments if management cannot convert sales into prof its. In his expe-
rience, managers of high-cost operations tend to f ind ways that
continually add to overhead, whereas managers of low-cost operations
are always f inding ways to cut expenses.
Buffett has little patience for managers who allow costs to esca-
late. Frequently these same managers have to initiate a restructuring
program to bring down costs in line with sales. Each time a company