COCA COLA & BUFFET (source: article here)

Throughout 1988 and 1989, Warren Buffett acquired more than $1 billion of Coca-Cola (KO) stock. At the time, Wall Street thought he was downright crazy. After all, Wall Street scrutinized the purchase and deduced that Buffett has paid way too much for earnings and the stock price was high—having run up 18% a year for eight years.

In 1988, Wall Street said Coca-Cola was a bad stock to buy. Warren Buffett thought it was a wonderful business to own. The results speak for themselves; so, let's look at the reasoning behind Warren Buffett's most famous purchase.

The Cash Cow

From 1978 through 1987, Coca-Cola's Free Cash Flow grew at a median rate of 21.8% a year. Then again, Coca-Cola's Free Cash Flow grew fairly steadily each year—a definite plus!

The Net Worth

Coca-Cola's Shareholder Equity had been growing about 7.8% a year. Not stellar by any means, but it was consistent and predictable—both staples in the Buffett approach to investing. The growth rate of Shareholder Equity becomes critically important only when you expect your company to close up shop in the next twenty years—clearly not in the stars for Coca-Cola.

Management And Money

Coca-Cola had a median CROIC of 9.3% for ten years. For every dollar of capital invested in the company, Coca-Cola was generating $0.09 of cash. Then again, Coca-Cola was a special situation because of its brand and moat.

Brand And Moat

A company that needs no introduction, Coca-Cola was the company in the beverage industry...and in the world. It dominated the market and had no serious competition. Picture a world where there was practically no Pepsi, Snapple, or bottled water on the shelves—just Coke. That is pretty much 1988. In 1988, you would have been hard pressed to find a more well-known name than Coca-Cola. Now that is moat.

The Valuation

Assuming the company could continue to grow Free Cash Flow at 21.8% a year for ten years, and then slowed to 5% thereafter, and assuming Buffett wanted a 15% or more average annual return, you could value Coca-Cola at $22.3 billion, or $59.16 a share in 1988.

For new readers: The $22.3 billion is made up of $2.09 billion of Shareholder Equity and the net present value of the estimated $98.89 billion of future cash flow, discounted at 15% for a handsome return.

The Purchase

Of course, you shouldn't pay full price for a company—even one as solid as Coca-Cola. If the future is a little less rosy than you projected, your returns head south. So, you need a discount. Being an industry leader (the industry leader), Coca-Cola could have been purchased with as little as a 25% Margin Of Safety (discount). At a 25% discount to value, Coca-Cola could have been purchased at any time at or below $44.37. In 1988, the company's stock traded between $35 and $45.25, giving Buffett a discount between 24% and 41%.

The Result

Today, Buffett's stock in Coca-Cola is worth more than $10 billion, and he collects more than $270 million a year in dividends. Not bad, considering how easy it was to find the value in this "no-brainer" investment.

Wall Street thought Buffett was nuts. In 1987, earnings were down nearly 2% from their 1986 peak—surely not the sign of a growing company! With a price-to-earnings ratio of 14 to 19, the company seemed fairly valued at best, if not overvalued.

And once again, Buffett showed the world why Wall Street's earnings mean nothing to the business investor, how to invest like a business owner, and why you are right when your data and reasoning are right—not because the crowd agrees or disagrees.