Concept of Equity Bond of Warren Buffett

Concept of “Equity Bond” of Warren Buffett.

Elaboration of Section 7

This section introduces a powerful mental model used by Warren Buffett that fundamentally changes how one should view a stock investment. It reframes a share of stock not as a speculative ticker symbol, but as a kind of "bond" with unique and superior characteristics.

The core of the concept is broken down into three parts:

1. The Theory: Stock as an "Equity Bond"
Buffett observes that companies with strong, predictable earnings—especially those with a Durable Competitive Advantage (DCA)—can be analyzed similarly to bonds, but with a crucial twist.

• The Analogy:

  • Equity Bond = The Share Price (This is the principal you invest).

  • Bond Coupon = The Company's Pre-Tax Earnings Per Share (This is the annual "interest" the business earns on your behalf).

• The Critical Difference: A normal bond's coupon (interest rate) is fixed. However, for a great company, the "coupon" (its earnings per share) increases year after year because the business is growing. This means the "Equity Bond" becomes more valuable over time.

2. Determining the Share Price (Valuation)
The section explains how the stock market typically values these "Equity Bonds." The price is influenced by the level of long-term interest rates.

• The Formula: The theoretical value of the Equity Bond is calculated by comparing its "coupon" to the prevailing interest rate on Long-Term Corporate Bonds (LTCBR).

  • Equity Bond Value = Coupon Rate / L.T. Corporate Bond Rate

  • Or, more simply: Share Price = Pre-Tax Earnings Per Share / L.T. Corporate Bond Rate

• Examples from the text:

  • The Washington Post (2007): Pre-tax EPS of $54 / 6.5% Bond Rate = $830 per share theoretical value. Its actual price traded around this range ($726-$885).

  • Coca-Cola (2007): Pre-tax EPS of $3.96 / 6.5% Bond Rate = $61 per share theoretical value.

• The Interest Rate Relationship: This model explains why stock prices are sensitive to interest rates.

  • When Interest Rates FALL, the same earnings are worth more (because you are dividing by a smaller number), so share prices tend to rise.

  • When Interest Rates RISE, the same earnings are worth less, so share prices tend to fall.

3. The Investment Decision: When to Buy and Sell
This mental model directly informs Buffett's buying and selling criteria.

• When to Buy:

  • The lower the price you pay, the higher your initial "coupon" (yield) and the greater your long-term return. The example shows that buying Coca-Cola at $6.50 gave Buffett a massive future yield, whereas buying at $21 would have yielded far less.

  • The best time to buy is during bear markets, when wonderful businesses are often sold at a discount to their theoretical value. This is the practical application of being "greedy when others are fearful."

• When to Sell (or Not Buy):

  1. To free up cash for a better opportunity (a company with a higher potential yield).

  2. When the company is losing its Durable Competitive Advantage (the "moat" is disappearing).

  3. During bull markets, when stock prices are driven "through the ceiling" far beyond their long-term economic value. This is when to be "fearful when others are greedy."

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Summary of Section 7

Section 7 explains Warren Buffett's "Equity Bond" concept, a mental model that treats a share of a wonderful company as a bond whose interest payment (the company's earnings) grows every year.

• Core Concept: A stock is an "Equity Bond" where the share price is the bond's face value and the company's pre-tax earnings per share is the bond's interest payment.

• Key Advantage: Unlike a normal bond with a fixed coupon, the "coupon" of an Equity Bond from a great company increases over time, dramatically increasing the value of the original investment.

• Valuation Insight: The fair price of this Equity Bond is influenced by long-term interest rates. Lower rates justify higher stock prices, and vice-versa.

• Practical Application: This model dictates a clear strategy:

  • BUY when you can purchase this high-quality Equity Bond at a low price, giving you a high initial and growing yield.

  • SELL if the business's moat collapses, the price becomes irrationally high, or a far better Equity Bond becomes available.

In essence, this concept forces the investor to think like a business owner, focusing on the underlying earnings power of the company and the price paid for it, rather than on short-term stock price fluctuations. It is a cornerstone of value investing that links business fundamentals directly to investment returns.