Equity Bond Theory assumes the stock of a company with a Durable Competitive Advantage is equivalent to bonds. It compares the Rate of Return of a company to the Rate of Return of bonds. It is Warren Buffett's embodiment of value and growth investing.
Bonds are divided into 2 categories:
- Taxable Bonds
- Tax Free Municipal Bonds
When compared to Taxable Bonds, the Rate of Return of a company is the ratio Before Tax Income to Market Capitalization. When compared to Tax Free Municipal Bonds, the Rate of Return is the ratio After Tax Income to Market Capitalization. As for bonds, the Rate of Return is the interest payments.
The stock of a company with a Durable Competitive Advantage is just as stable as bonds. And their Rates of Return may be compared to each other. What Warren Buffet's Equity Bond Theory does is determine which investment will give the larger Rate of Return. Stocks? Or Bonds?
Equations
Warren Buffet's Equity Bond Theory compared to a Taxable Bond:
Warren Buffet's Equity Bond Theory compared to a Tax Free Municipal Bond:
While the interest rate on a bond is fixed year after year, the Income of a company with a Durable Competitive Advantage grows year after year. Therefore, the value of the company's stock also grows.
Value and growth are not separate. They are related to each other. There are economic conditions when the Rate of Return of a company with a Durable Competitive Advantage is greater than the Rate of Return of bonds. When that happens, it may be a wise to buy stock in that company. And what you would get is a growth stock purchased at a value price.
In general:
- If the Rate of Return of a stock is greater than the Rate of Return of a bond. Buy the stock.
- If the Rate of Return of a bond is greater then the Rate of Return of a stock. Buy the bond.
- Any investment with a Rate of Return greater than 10% is awesome.
Example 1
On March 21, 2011, the Coca-Cola Company's price per share was around $61.50. It has 2.3 Billion shares outstanding which places it at a Market Capitalization of $141.45 Billion. It's Income Before Tax is $14.243 Billion for the year 2010.
Date: March 21, 2011
Company: Coca-Cola
Price/Share: $61.50
Shares: 2.3 Billion
Market Capitalization: $141.45 Billion
Income Before Tax (2010): $14.243 Billion
As of March 2011, the Corporate Bond Weighted Average Interest Rate (CB Wtd Avg) is 6.08%.
Coca-Cola's Rate of Return: 10.07%
CB Wtd Avg: 6.08%
At $61.50 per share, the Rate of Return of the Coca-Cola Company is 10.07%, greater than the average Rate of Return of a Corporate Bond at 6.08%. Thus, according to Warren Buffet's Equity Bond Theory, Coca-Cola is the better investment.
Example 2
On July 8, 2011, the NetFlix's price per share was around $295. It has 55.4 Million shares outstanding which places it at a Market Capitalization of $16.343 Billion. It's Income After Tax is $160.85 Million for the year 2010.
Date: July 8, 2011
Company: NetFlix
Price/Share: $295
Shares: 55.4 Million
Market Capitalization: $16.343 Billion
Income After Tax (2010): $160.85 Million = $0.16085 Billion
As of July 8, 2011, there are Tax Free Municipal Bonds that have Interest Rates of around 4.00%.
NetFlix's Rate of Return: 0.98%
Tax Free Municipal Bond Interest Rate : 4.00%
At $295 per share, the Rate of Return of the NetFlix is 0.98%, much less than the Tax Free Municipal Bond Interest Rate of 4.00%. Thus, according to Warren Buffet's Equity Bond Theory, the Tax Free Municipal Bond is the much better investment.
Example 3
On February 11, 2016, the IBM's price per share was around $120. It has 960.88 Million shares outstanding which places it at a Market Capitalization of $115.305 Billion. It's Income Before Tax is $15.945 Billion for the year 2015.
Date: February 11, 2016
Company: IBM
Price/Share: $120
Shares: 960.88 Million
Market Capitalization: $115.305 Billion
Income Before Tax (2015): $15.945 Billion
IBM's Rate of Return: 13.83%
Awesome Rate of Return : 10%
At $120 per share, the Rate of Return of the IBM is 13.83%, which is greater than 10%. Any investment that will give us a Rate of Return that is greater than 10% is awesome.