I'm reading Warren Buffett and the Interpretation of Financial Statements and quote:

Consider this: With long-term corporate interest rates at approximately 6.5% in 2007, Warren’s Washington Post equity bonds/shares, with a pretax $54 earnings/interest payment, were worth approximately $830 per equity bond/share that year ($54 ÷ .065 = $830). During 2007, Warren’s Washington Post equity bonds/shares traded in a range of between $726 and $885 a share, which is right about in line with the equity bond’s capitalized value of $830 a share.

I have multiple questions:

  1. The long-term corporate interest rates does not seem to reach 6.5% in 2007, according to these following links. Am I looking at the wrong place?
    1. https://www.macrotrends.net/2015/fed-funds-rate-historical-chart
    2. https://fred.stlouisfed.org/tags/series?t=interest+rate%3Blong-term%3Busa
  2. I'm not sure if I understood the equity bond in this chapter. The author is relating the reciprocal of P/E ratio to the current long-term interest rates, why is that? The logic seems to be the following:
    1. With the rate at 6.5%, the P/E ratio should be 100/6.5=15.38, so the estimated stock price should be $54*15.38=$830.
    2. If a company has durable competitive advantage and its stock has a P/E ratio lower than 15.38, it would be good to invest.

1 Answer 1

  1. You're looking at government rates, not corporate rates. Corporate rates are higher due to the risk of default.

  2. Buffet's "equity bond" method looks at how much you get in earnings as a percentage of the share price. In other words, what "interest" do you get for treating the stock as if it were a bond? Is that interest higher or lower than you get from an equivalent corporate bond?

Like many of Buffet's metrics and strategies, they look at very simple metrics to find discrepancies, then dig deeper using other metrics to see if those discrepancies can be exploited. It's not meant to be taken as absolute truth or taken in a vacuum.

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