124 THE WARREN BUFFETT WAY
enough to project the long-term earnings potential of any company
within it.
This brings us to the second element in the formula: What is the
appropriate discount rate? Buffett’s answer is simple: the rate that
would be considered risk-free. For many years, he used the rate then
current for long-term government bonds. Because the certainty that the
U.S. government will pay its coupon over the next thirty years is virtu-
ally 100 percent, we can say that this is a risk-free rate.
When interest rates are low, Buffett adjusts the discount rate up-
ward. When bond yields dipped below 7 percent, Buffett upped his dis-
count rate to 10 percent, and that is what he commonly uses today. If
interest rates work themselves higher over time, he has successfully
matched his discount rate to the long-term rate. If they do not, he has
increased his margin of safety by three additional points.
Some academicians argue that no company, regardless of its
strengths, can assure future cash earnings with the same certainty as a
bond. Therefore, they insist, a more appropriate discount factor would be
the risk-free rate of return plusan equity risk premium, added to ref lect
the uncertainty of the company’s future cash f lows. Buffett does not add
a risk premium. Instead, he relies on his single-minded focus on com-
panies with consistent and predictable earnings and on the margin of
safety that comes from buying at a substantial discount in the f irst place.
“I put a heavy weight on certainty,” Buffett says. “If you do that, the
whole idea of a risk factor doesn’t make any sense to me.”^4
Coca-Cola
When Buffett f irst purchased Coca-Cola in 1988, people asked:
“Where is the value in Coke?” Why was Buffett willing to pay f ive
times book value for a company with a 6.6 percent earning yield? Be-
cause, as he continuously reminds us, price tells us nothing about value,
and he believed Coca-Cola was a good value.
To begin with, the company was earning 31 percent return on eq-
uity while employing relatively little in capital investment. More im-
portant, Buffett could see the difference that Roberto Goizueta’s
management was making. Because Goizueta was selling off the poor-
performing businesses and reinvesting the proceeds back into the
higher-performing syrup business, Buffett knew the f inancial returns