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]].

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]].

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.

Does FB make for an intelligent investment or intelligent speculation today? Starting with a base estimate of annual Free Cash Flow at a value of approximately $950,000,000 and the number of shares outstanding at 2,140,000,000 shares; we used an assumed FCF annual growth of 15 percent for the first 10 years and assume zero growth from years 11 to 15. Review the Free Cash Flow record here:

http://quicktake.morningstar.com/stocknet/CashFlowRatios10.aspx?Country=USA&Symbol=fb&stocktab=keyratio

The resulting estimated intrinsic value per share (discounted back to the present) is approximately $11.14.

Market Price = $34.03
Intrinsic Value = $11.14 (estimated)

I used a discount rate of 6.25% and the Moat appears to be narrow and shallow. The Moat can last as long as Google or Yahoo or Microsoft do not design a friendlier website. Once one of the big cloud providers designs a friendlier interface, the moat starts eroding.

For example, if Google plus was easier to use, and it added features like a friendlier ebay style trading/barter/consulting it could take the lead. Thus far Google+ is too cumbersome and geeky to be useful. However, they are trying to make it better.

Bud Labitan
author of "The Four Filters Invention of Warren Buffett & Charlie Munger" and "Moats: The Competitive Advantages of Buffett & Munger Businesses"

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Disclosure: I am long [[BRK.A]], [[BRK.B]].

Wells Fargo is a well-managed, high-return banking operation in which Berkshire Hathaway increased its ownership to around 11%. About one-sixth of the position was bought in 1989, the rest in 1990 and 2010.

Buffett wrote: "The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the foolish behavior of their peers. Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a "cheap" price."

With Wells Fargo, Buffett was thinking about "the best managers in the business, Carl Reichardt and Paul Hazen." He liked the pair of managers. Both managed costs wisely when profits were at record levels as well as when they are under pressure. Both managers did what they understood and did not let their egos determine what they attempt.

Buffett's Berkshire purchases of Wells Fargo in 1990 were helped by investors' flight away from bank stocks. Berkshire purchased a 10% interest in Wells Fargo for $290 million, which was less than five times after-tax earnings. Interestingly, Buffett did a similar move to buy more Wells Fargo stock in 2010 for similar bargain reasons.

Wells Fargo is big, and it has been earning higher than average returns on equity and returns on assets. The purchase of one-tenth of the bank has been described as roughly equivalent to Berkshire buying 100% of a $5 billion bank with identical financial characteristics.
Buffett described these risks. California banks face the specific risk of a major earthquake that could destroy banks. Another risk is a systemic risk. This almost came true during the great recession of 2008 and 2009. Buffett described this as: "the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run."

In the recent financial crisis, WFC and other major banks were forced by the U.S. government to undergo stress tests and take infusions of cash in an effort to moderate the great credit crisis. Charlie Munger said Wells Fargo and U.S. Bancorp avoided many of the banking mistakes that led to the worldwide credit crisis and recession.

Buffett wrote that a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. In late 1980s, the market's major fear was that West Coast real estate values would tumble because of overbuilding. Because WFC was and is a leading real estate lender, Wells Fargo is thought to be vulnerable. Fears of a California real estate disaster caused the price of Wells Fargo stock to fall almost 50% in 1990. He welcomed the decline because it allowed him to buy more shares at the new, panic prices.

Wells Fargo & Company (NYSE:WFC), is the fourth largest bank holding company in the United States. It is best classified as a diversified financial services company with over 80 distinct businesses. WFC offers a full range of financial products and services. It targets all types of clients in all 50 states and the District of Columbia.

In 2010, Wells Fargo earned a total of $85 billion in total revenues and a net income of $12.4 billion. After acquiring Wachovia, it became the nation's largest mortgage lender and the second-largest diversified financial service deposits firm in the United States.

As part of the TARP deal to raise enough cash for the Wachovia rescue acquisition, Wells Fargo's sold $12.6 billion in common stock and $25 billion in preferred stock to the US Government through the $700 Billion Troubled Assets Relief Program (TARP).

Like all major banks, Wells Fargo has been negatively impacted by the credit crunch and the economic decline. However, Wells Fargo was not forced to write down large losses on its assets.

Wells Fargo raised $12.25 billion in a stock sale to help repay the $25 billion in Troubled Assets Relief Program (TARP) crisis money. Although this diluted Wells Fargo's shares by approximately ten percent, it allows the bank to avoid paying an annual dividend to the government of $1.25 billion. This also frees WFC from added government oversight.

Wells Fargo separates its businesses into three main segments for revenue reporting purposes: 1.) Community Banking, 2.) Wholesale Banking, and 3.) Wealth, Brokerage, and Retirement. Wells Fargo's Community Banking business serves small business clients as well as retail customers. It also provides a wide range of services in investment, insurance, and trust services to high-net-worth individuals.

WFC offers its products through a variety of channels, including the company's regional banking branches, over 6,700 ATMs, website, and telephone banking service. Wells Fargo's large credit card business, now part of its Community Banking, has issued over 7.7 million credit cards and over 20 million debit cards. This makes it the second largest debit card issuer in the U.S. As a credit card issuer, it charges interchange fees, interest on outstanding customer balances, and fees such as late or missing payment fees, exceeding credit limit fees, and monthly or annual membership fees.

Wells Fargo's Wholesale Banking Group serves business clients with annual sales exceeding $10 million. Wholesale Banking is responsible for a line of corporate, commercial, and real estate banking products and services. This includes institutional investments, employee benefit trusts, investment banking, construction loans, and insurance.

After the Wachovia Bank acquisition, WFC was also able to expand its product services to include investment banking, equity trading, fixed-income sales and trading, and equity and fixed-income research.

Wells Fargo has also teamed up with Visa (V) to pilot test a mobile payments system. Competition for mobile payments dominance between credit card companies and telecom companies may have huge implications for future earnings as this market develops.

Wells Fargo's mortgage lending business was hit by slow growth and falling residential real estate prices. The number of total housing starts fell about 63% since peak levels during the end of the housing boom. However, Wells Fargo dealt with mortgage setbacks relatively well due to its wide diversification in product offerings.

The housing slowdown is often attributed to the collapse of the subprime lending market. Wells Fargo fared better than most competitors in the mortgage business because its mortgages are predominately prime and near-prime. As a result, Wells Fargo did not experience the high rates of default seen in the subprime market. Wells Fargo has avoided much of these losses by deciding not to extend or purchase option adjustable rate mortgages (option ARMs). However, the Wachovia Bank, acquired by Wells Fargo at a bargain, took part in Option ARMs and subprime lending.

With 6,795 branches and $760 billion in total domestic deposits, Wells Fargo focuses its business operations on the domestic U.S. market. Its major competitors include Bank of America (BAC), JP Morgan Chase (JPM), and Citigroup (C).

Wells Fargo is strongly focused on the United States market. Wells Fargo has less international exposure than its top competitors. While this does allow Wells Fargo to focus its resources on gaining greater market share within the U.S., it is more vulnerable to U.S. economic cycles. WFC does not have foreign markets to buffer domestic performance.

According to John Stumpf, Chairman and CEO, Wells Fargo's biggest competitive advantage is its employees. The company looks for talents in different cultures and backgrounds and provides them with the necessary training. Wells Fargo's culture recognizes and rewards an outstanding performance. As a result, twenty seven years is an average tenure for Wells Fargo's wholesale leadership members.

Wells Fargo also focuses on customer retention. It has over ten year long relationships with forty percent of its customers. Such high retention rates enable cross-selling of products. In 2009, an average number of products per wholesale relationship were 6.47, a steady increase from 4.84 in 2003.

Recently, WFC's 5Yr Net Profit Margin (5-Year Avg.) is approximately 15.4%, while the industry Net Profit Margin (5-Year Avg.) is 16.5%, and the S&P Net Profit Margin (5-Year Avg.) is 11.5%.

Wells Fargo also uses its size and financial reserves as a competitive advantage. The current economical crisis has shown that no bank is too big to fail. Therefore, Wells Fargo will have to stay with its core values by focusing on its current customers and refrain from assuming too much risk in the mortgage market.

Bud Labitan
author of "The Four Filters Invention of Warren Buffett & Charlie Munger" and "Moats : The Competitive Advantages of Buffett & Munger Businesses"

Disclosure: I am long [[BRK.A]], [[BRK.B]].

Many volunteers contributed research to this fine book about business competitive advantages. In an effort to raise awareness for MOATS : Competitive Advantages of 70 Buffett & Munger Businesses, I am releasing a free 20 chapter abridged version over the internet in pdf form.

You can download your copy here: http://www.frips.com/moats20.pdf

Feel free to respond with constructive criticism. Perhaps we can include your findings in the second edition next year.

MOATS may currently be the best business book that describes the competitive advantages of profitable businesses. However, being a self-published project without a big publishing house marketing effort, it has been floating under the radar of awareness of serious financial journalists. Therefore, this free 20 chapter abridged version is released to get people talking about it, as well as critically reviewing its content.

MOATS describes the nature of 70 selected businesses purchased by Buffett and Munger for Berkshire Hathaway Inc. MOATS is a very useful resource for investors, managers, students of business. Since its subject matter has proven success, MOATS may become a useful practical text in businesses schools around the world. MOATS also looks at the sustainability of these competitive advantages in each of the 70 chapters. The author extends a special thanks to Professor Phani Tej Adidam, Ph.D. Chair of the Department of Marketing and Management and Director of the CBA International Initiatives at University of Nebraska at Omaha. Thanks are extended to Richard Konrad, CFA, Dr. Maulik Suthar, and Scott Thompson, MBA for sharing their thoughts, analysis, and feedback.

The 70 Businesses covered in MOATS:

Acme Brick Company, w Adam Ward
American Express Co. (AXP), Dr. Maulik Suthar
Applied Underwriters, w Adam Ward
Ben Bridge Jeweler, w Beryl Chavez Li
Benjamin Moore & Co., w Mr. Jack Wang CPA
Berkshire Hathaway Group, w Brian Greising & Rick Mayhew
Berkshire Hathaway Homestate Companies, w Beryl Chavez Li
BoatU.S., w Peter Chen
Borsheims Fine Jewelry, w Tariq Khan.
Buffalo News, Bud Labitan & Peter Stein
Burlington Northern Santa Fe Corp. w David Leoy.
Business Wire, w Larry Harmych.
BYD, w Kevin Walsh.
Central States Indemnity Company, w Azalia Khousnoutdinova,
Clayton Homes, w Erin Sestak.
Coca Cola (KO) w Sebastian Jung,
ConocoPhillips (COP), w Adam D. Studts, PE.
CORT Business Services, w Erin Sestak.
Costco Wholesale (COST), w Jubin Jacob, AUC-SOM
CTB Inc., w Todd Sullivan.
Fechheimer Brothers Company, w Ben Albaitis.
FlightSafety, w Peter Stein
Forest River, w Richard Konrad, CFA
Fruit of the Loom®, Dr. Maulik Suthar
Garan Incorporated, w Dr. Edwin Fuentes
Gateway Underwriters Agency, assigned Daniel Rudewicz, CFA
GEICO Auto Insurance w Florian Beil,
General Re, w Raghu Dasari, & Theodor Tonca
H.H. Brown Shoe Group, w Mervyn H. Teo
Helzberg Diamonds, w Natalja Callahan
HomeServices of America, w Sebastian Jung
IBM, w Tim Bishop & Peter Stein
International Dairy Queen, Inc., w Tariq Khan
Iscar Metalworking Companies, w Kevin Walsh
Johns Manville, w Manpreet Singh Saran
Johnson & Johnson (JNJ), Beryl Chavez Li
Jordan's Furniture, w Zehao Sun.
Justin Brands, Dr. Maulik Suthar
Kraft Foods (KFT), w Andrea Tagart.
Larson-Juhl, w Tim Bishop
Lubrizol, w Scott Thompson, MBA.
M&T Bank Corp (MTB), w Cliff Orr & Richard Konrad, CFA
Marmon Holdings, Inc., w David Lau & Theodor Tonca
McLane Company, Dr. Maulik Suthar,
Medical Protective, w Michael Murillo
MidAmerican Energy Holdings Company, w Dr. Maulik Suthar & Brian Bernardino, JD
MiTek Inc. w Mr. Jack Wang CPA
Moody's (MCO), w Raghu Dasari
National Indemnity Company, w Jen Iwanski & Rick Mayhew
Nebraska Furniture Mart, w Julie Rosenbaugh, Theodor Tonca, & Shouryamoy Das
NetJets®, w Christian Labitan
PacifiCorp., w Beryl Chavez Li
Precision Steel Warehouse, Inc., w Adam D. Studts, PE & J.T. Loudermilk, MBA
Procter & Gamble (PG), w Beryl Chavez Li
RC Willey Home Furnishings, w Azalia Khousnoutdinova
Richline Group, Daniel Doyon
Scott Fetzer Companies, Cliff Orr & Hoang Quoc Anh, Vietnam
See's Candies, w Jen Iwanski
Shaw Industries, w Daniel Doyon & Richard Konrad, CFA
Star Furniture, w Pamela A. Quintero, MBA
The Pampered Chef® w Julie Rosenbaugh
TTI, Inc., w Peter Chen
United States Liability Insurance Group, w Stephen Chan & Colin Farrier
US Bancorp (USB), w Richard Konrad, CFA
USG Corp (USG), w Richard Konrad, CFA
Wal-Mart (WMT) w Florian Beil
Washington Post (WPO), w Andrea Tagart & Richard Konrad, CFA
Wells Fargo (WFC), w Natalja Callahan.
Wesco Financial Corporation, w Stephen Chan
XTRA Corporation, Bud Labitan

Disclosure: I am long [[BRK.A]], [[BRK.B]], [[JNJ]], [[AXP]], [[USB]], [[PG]].

Additional disclosure: Many volunteers contributed research to this fine book about business competitive advantages. In an effort to raise awareness for MOATS : Competitive Advantages of 70 Buffett & Munger Businesses, I am releasing a free 20 chapter abridged version over the internet in pdf form.