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

As stated earlier, in 1987 Warren started buying shares in Coca-Cola for an average price of $6.50 a share against pretax earnings of $.70 a share; this equates to after-tax earnings of $.46 a share. Historically, Coca-Cola’s earnings had been growing at an annual rate of around 10%. Seeing this, Warren could argue that he had just bought a Coca-Cola equity bond paying an initial pretax interest rate of 10.7% on his $6.50 investment. He could also argue that that pretax yield would increase over time at a projected annual rate of 10% (Coca-Cola’s average annual rate of earnings growth for the ten years prior to 1987).


So what was a pretax 66% return on a $6.50 equity bond in 2007 worth in 1987? It depends on the discount rate that we use. If we use 7%, which is right about what long-term rates were back then, we get a discounted back value of approximately 17%. Multiply 17% by the $6.50 a share he was paying for and we would get $1.10 a share. Multiply $1.10 by Coca-Cola’s 1987 P/E of 14 and we get $15.40 per share. Thus Warren could have argued in 1987 that he was buying an equity bond for $6.50 a share, and that if he held it for twenty years, its 1987 intrinsic value really would be $15.40 a share.

I'm unable to understand the numbers in the paragraph:

  1. Where does the 17% came from?
  2. Why multiply $6.5 with the 17% percentage?
  3. The rest is fine to me, I understand the author is trying to compare the intrinsic value against the current stock price


You must log in to answer this question.

Browse other questions tagged .