Investing Guidelines: Value Tenets 125of Coca-Cola were going to improve. In addition, Goizueta was buying
back shares of Coca-Cola in the market, thereby increasing the eco-
nomic value of the business even more. All this went into Buffett’s
value calculation. Let’s walk through the calculation with him.
In 1988, owner earnings of Coca-Cola equaled $828 million. The
thirty-year U.S. Treasury Bond (the risk-free rate) at that time traded
near a 9 percent yield. So Coca-Cola’s 1988 owner earnings, discounted
by 9 percent, would produce an intrinsic value of $9.2 billion. When
Buffett purchased Coca-Cola, the market value was $14.8 billion, 60
percent higher, which led some observers to think he had overpaid. But
$9.2 billion represents the discounted value of Coca-Cola’s then-
current owner earnings. If Buffett was willing to pay the higher price,
it had to be because he perceived that part of the value of Coca-Cola
was its future growth opportunities.
When a company is able to grow owner earnings without addi-
tional capital, it is appropriate to discount owner earnings by the differ-
ence between the risk-free rate of return and the expected growth of
owner earnings. Analyzing Coca-Cola, we f ind that owner earnings
from 1981 through 1988 grew at a 17.8 percent 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 extraordinary growth for a certain number of
years and then a period of constant growth at a slower rate.
We can use this two-stage process to calculate the 1988 present
value of the company’s future cash f lows (see Table 8.1). First, assume
that starting in 1988, Coca-Cola would be able to grow owner earnings
at 15 percent per year for ten years. This is a reasonable assumption,
since that rate is lower than the company’s previous seven-year average.
By the tenth year, the $828 million owner earnings that we started
with would have increased to $3.349 billion. Let’s further assume that
starting in the eleventh year, growth rate will slow to 5 percent a year.
Using a discount rate of 9 percent (the long-term bond rate at the
time), we can back-calculate the intrinsic value of Coca-Cola in 1988:
$48.377 billion (see Notes section at the end of this book for details of
this calculation).^5
But what happens if we decide to be more conservative, and use
different growth rate assumptions? If we assume that Coca-Cola can
grow owner earnings at 12 percent for ten years followed by 5 percent