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Yield On Cost Is Warren Buffett's Coca-Cola Magic

By Bud Labitan

A nagging feeling came over me while finishing this latest book with the help of my friend Scott Thompson. While I was happy with our new book "1988 valuation of Coca-Cola: Estimated Intrinsic Value," I felt like we did not fully explain the importance, value, and power of that bargain purchase. How could a man who wrote a book on Buffett and Munger's "Four Filters Invention" investing process, "Price To Value," and "MOATS," fail to understand the power of this purchase?

I started emailing friends and doing simple, somewhat crazy math estimations to see if I could find the truth myself. I am even embarrassed to say that I sent an email to Mr. Buffett with flawed math. Friends, with their good intentions, would tell me to return to "Time Value of Money" calculations, and learn those well. They would say something like, Coca-Cola is a great company with nice rate of returns and steadily increasing dividends, but it only gives you a range of 9-11% returns.

I would think, "How can that be?" "My investing heroes, Warren Buffett and Charlie Munger" always smile and resist cries from shareholders to sell the the Coca-Cola, KO shares. What I rediscovered is; the Magic of Warren Buffett's and Charlie Munger's 1988 purchase of Coca-Cola stock is: "YIELD ON COST."

Think of "Yield On Cost" as "Yield Relative To MyCost" or "The Yield received PerShareCost" or Yield / PerShareCost. No, those are not typo errors. I intentionally removed the spaces. It can be described as "yield / cost per share."

I sort of backed into finding that bond concept. My initial thinking went something like this: Think of it as getting an average of a $570,000,000 dividend every single year from that principal investment cost of $1.299 Billion in Coca-Cola. If you multiply $570,000,000 x 24 years, we get 13.15 billion. Add this 13.15 to the 1.29 billion principal, and we get very very close to the current value of $14.44 billion in BRK's ownership of Coca-Cola.

Bear with me on this basic "non-compounding" math below and you will see how Warren received about $570,000,000 for every year of that his principal investment of $1.299 Billion in Coca-Cola. Keep in mind, I was trying to stay with simple math. Look at their cost of 1.299 billion, 0.44 rate of average annual return, and 0.57, which represents my assumption of $570,000,000

0.57 x 23 (23 because of end of year adjustment), Plus ½ of year of approximately 0.29, so 1.299 + 13.43 = 14.73, is darn close.

I found an old 2010 article that said: When Buffett began purchasing stock in Coca Cola in 1988, many Wall Street analysts were skeptical because it seemed only a matter of time before other beverage companies would take away its market share. In addition, Coca-Cola had reported earnings down 2 percent from the previous year, and had an unimpressive P/E ratio of between 14 to 19. At the time, shares of KO were worth between $35 and $45. The stock has split three times since then, and is now priced in the $60 range. By 1995, Buffett owned 100,000 shares of the company with a cost basis of roughly $1.2 billion. As of September 2010, Buffett's unrealized gains on KO were $10.4 billion. This comes out to a 766 percent increase in value. This is one of Buffett's greatest investing triumphs. Google that article above.

Using the same simple logic... When $2 grows into $6, no matter the duration, we say 6/2=3 and 3*100 = a 300% increase in value, no matter if it takes 1 or 900 years. In this simple math, duration is irrelevant.

Now, by 2013, KO stock had split 4 times and BRK has 400,000,000 shares with a cost basis of $1.299 billion, and a market value of $14.5 billion. Forget for a moment that it took about 24.5 years to get there. Furthermore, suspend the idea of splits because we know the cost and the present dollar value that is already split-adjusted.

When 1.299B grows to 14.500B, we say 14.500/1.299=11.16 and *100 is a 1,116% increase in value. Again, in simple math, how much can we allocate to each year? Let us use a simple average and make it even. Now, a simple rough average of 1116/24.5years=45.55% approximate gain per year, and this does not even count the value of the dividends.

(NEXT, I GET A LITTLE THEORETICAL…) Let us add in the low-ball but fair figure of 5 billion for all the dividends (with no major Time Value of Money adjustments). When 1.299 grows to 19.500, we say 19.500/1.299=15.01 and *100 is a 1,501% increase in value. Now, a simple rough average of 1501/24.5years=61.27% gain in value (on top of the 1.29Billion) per year, or around $570,000,000 million each year.

Now, I felt like I was getting close to why Warren Buffett's 1988 bargain purchase of KO is so powerful and important. Next, I got a nice email from Richard Griebe. Richard said he was starting to see the way I was looking at this investment in KO. "Rather than looking at the compounding of value over time, you are looking at the average annual increase in value against the original $1.299 B invested. So, if I think of the original stock purchase as buying a bond instead, that "bond" has paid a continuously increasing interest rate over time. Following your computations to where you included dividends to calculate an average 61.27% gain per year or, in my bond model, Warren bought a bond for $1.299B that has paid on average coupon of 61.27% annually. This is a feat that would make gangsters jealous… Thanks for patiently discussing this fascinating case study with me.

With Richard's positive words, I felt encouraged, and I thanked him. Next, I kept searching the internet for this "yield" concept that I was looking for. I was looking for Warren Buffett's effective yield per share compared to my yield per share. I stumbled upon the concept of YIELD ON COST.
WOW ! That is it ! Yield per "Share Cost"

Did I realize that 1.299b/400m shares = Warren Buffett's $3.25 per share cost per share of KO? Did you?

From the website Investopedia: www.investopedia.com/terms/y/yield-on-cost.asp Yield On Cost, YOC is defined as: "The annual dividend rate of a security divided by the average cost basis of the investments. It shows the dividend yield of the original investment. If the number of shares owned by the investor does not change, the yield on cost will increase if the company increases the dividend it pays to shareholders; otherwise it will remain the same.

To calculate yield on cost for a stock, an investor must divide the stock's annual dividend by the average cost basis per share and multiple the resulting number by 100 (to get a percentage). For example, an investor who purchased 10 shares of stock at $15 and 20 shares at $18 would have an average cost basis of $17/share ($15*10 + $18*20)/(10 + 20). If the annual dividend is $0.90 per share, the yield on cost would be 5.29% ($0.90/$17 * 100).

Using this information, and knowing that Buffett's cost per share of KO is $3.25, can I calculate his yield on cost for 2012? The 2012 dividends per share were: March 13, 2013 $0.28, Nov. 28, 2012 $0.26, Sept. 12, 2012 $0.26, June 13, 2012 $0.26, March 13, 2012 $0.26 and the sum is $1.30
So, $1.30 / $3.25 = .40 and .40 * 100 = 40%. Warren Buffett and Berkshire Hathaway received a 40% YIELD ON COST just for the year 2012 dividends alone!

Alternatively, and again thinking in bond-like thoughts, if we believe the $570,000,000 average return per year on top of the 1.299 billion principal. $570,000,000 / 400,000,000 shares is 1.43 and that is like a gain of 43% each year over the initial investment.

PREDICTION: Since 45% + 40% = 85%, I predict that the total yearly return will soon surpass the initial $1.29 billion cost basis of this Coca-Cola investment.

Disclosure: I am long KO, BRK.A.

This is a piece of freeware that I give out to help bring attention to my books on amazon.com and lulu.com. If you like it and find it useful for estimating the approximate "intrinsic value" of stocks and businesses, I would appreciate your mentioning my books to your friends.

Disclaimer: This free software was designed by Bud Labitan. He has no business association with Seekingalpha, and any errors or omissions in the software are his own. He does claim that it has been tested and it is safe to use. Use caution in your growth assumptions and discount rate when using this simplified valuation model.

(click to enlarge)

Bud Labitan, MD, MBA
is the author of several books including "The Four Filters Invention of Warren Buffett & Charlie Munger" , "Price To Value" , and "Moats: The Competitive Advantages of 70 Buffett & Munger Businesses"

Disclosure: I am long BRK.A, BRK.B, KFT.

A Rough Valuation of JPM with a penalty perspective.

Does JPM make for an intelligent investment or intelligent speculation today? Keeping in mind that valuations are estimations of the productivity of an ongoing business, how do we adjust in a penalty for the recent mark-to-market loss of about $2 billion in the first six weeks of the second quarter? For this risk taking debacle, and for simplicity sake, I adjust its forward growth rate downward. Think of it as an impairment to goodwill that places friction on potential forward growth rate.

Let us do a simplistic valuation of the stock's intrinsic value per share. Starting with a base estimate of annual net income flow at a value of approximately $17,500,000,000 and the number of shares outstanding at 3,810,000,000 shares; we use an assumed FCF annual growth of 5 percent for the first 10 years and assume zero growth from years 11 to 15. Review the Free Cash Flow record here: http://financials.morningstar.com/income-statement/is.html?t=JPM

The resulting estimated intrinsic value per share (discounted back to the present) is approximately $60.13.

Market Price = $33.5
Intrinsic Value = $60.13 (estimated)
Price To Value (P/V) ratio = .56 and the estimated bargain = 44. percent.

Before we make a purchase, we must decide ( filter #1 ) if JPM is a high quality business with good economics. Does JPM have ( filter #2 ) enduring competitive advantages, and does JPM have ( filter #3 ) honest and able management.

Some industries have higher ROE because they require no assets, such as consulting firms. Other industries require large infrastructure builds before they generate a penny of profit, such as oil refiners. Generally, capital-intensive businesses have higher barriers to entry, which limit competition. But, high-ROE firms with small asset bases have lower barriers to entry. Thus, such firms face more business risk because competitors can replicate their success without having to obtain much outside funding.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing; only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor. The wonderful companies sustain a competitive advantage, produce free cash flow, and use debt wisely.

Does JPM make for an intelligent investment or speculation today? Time is said to be the friend of the wonderful company and the enemy of the mediocre one. Before making an investment decision, seek understanding about the company, its products, and its sustainable competitive advantages over competitors. Next, look for able and trustworthy managers who are focused more on value than just growth. Finally ask: Is there a bargain relative to its intrinsic value per share today? If JPM can get its house in order, there may be a decent bargain here for the longer term investor.

Bud Labitan, MD, MBA
is the author of "The Four Filters Invention of Warren Buffett & Charlie Munger" and "Price To Value" and "Moats: The Competitive Advantages of Buffett & Munger Businesses"

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.