The Equity Bond (Financial Statements 5.1)

The Stock Market’s Best-Kept Secret

Equity Bonds: How They Made Warren Buffett Rich

Warren Buffett often talks about how certain companies with a durable competitive advantage generate such strong and predictable earnings growth that their shares function like an "equity bond."

Unlike a traditional bond, which pays a fixed interest rate, an equity bond provides an ever-increasing return—where the "coupon" or "interest payment" is the company’s pretax earnings.

This is exactly how Buffett evaluates businesses, whether he's buying a partial or full stake. He looks at pretax earnings and determines whether the purchase price offers a good deal relative to the company’s economic strength and durability.

The Power of Compounding Earnings

Companies with a durable competitive advantage benefit from strong business economics that drive consistent earnings growth. Over time, this leads to a rising stock price as the market recognizes the increase in intrinsic value. Per-share earnings grow through business expansion, acquisitions, or share buybacks using retained earnings.

Take Coca-Cola, for example. Buffett purchased shares in the late 1980s at an average price of $6.50 per share, when the company had pretax earnings of $0.70 per share and after-tax earnings of $0.46. With Coca-Cola’s earnings growing at an annual rate of about 15%, he essentially bought an "equity bond" that initially paid a 10.7% pretax yield on his investment—one that kept increasing annually.

Buffett then asked himself: Is this an attractive investment relative to the risk and return of other opportunities?

For Graham-style value investors, who focus primarily on a stock’s price rather than the business’s fundamentals, this might not seem compelling. But for Buffett, who plans to hold "equity bonds" for decades, it’s an ideal investment. Why? Because as earnings grow each year, his return on the original investment compounds, eventually reaching extraordinary levels.

The Market Always Catches Up

By 2007, Coca-Cola’s pretax earnings had grown to $3.96 per share—an annual growth rate of approximately 9%. This meant Buffett’s original $6.50 investment was now yielding a pretax return of 60% and an after-tax return of 40%.

With long-term corporate bond rates at 6.5% in 2007, Coca-Cola’s earnings of $3.96 per share, when capitalized at that rate (3.96 ÷ 0.065), were worth about $60 per share. That year, the market priced Coca-Cola between $45 and $64 per share—aligning closely with its intrinsic value.

One reason stock prices tend to follow a company’s growing intrinsic value is the potential for leveraged buyouts (LBOs). If a company with stable earnings becomes undervalued, another firm can step in, acquire it, and finance the purchase with the company’s own cash flows. Buffett has learned that as long as he buys businesses with durable competitive advantages, the market will eventually value their shares based on earnings relative to long-term corporate bond yields. This is why long-term interest rates influence stock valuations and overall market movements.

The Magic of Ever-Increasing Yields

Companies with strong competitive advantages generate earnings that consistently grow over time, making them an ever-increasing yield investment.

For instance, in 1998, Buffett purchased shares of Moody’s for $10.38 each, when the company had after-tax earnings of $0.41 per share. By 2007, Moody’s after-tax earnings had risen to $2.58 per share. This meant Buffett’s original investment was now yielding a 24% after-tax return (or 38% pretax).

While the stock market may take time to acknowledge such growth, it inevitably does—rewarding patient investors who recognize the power of compounding earnings.

That concludes this chapter. In the next section, we will explore the when to buy or sell a stock. Until then, invest safe!

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