Most people value shares by comparing the price with some estimate of what the business is “really worth”. Warren Buffett and the Interpretation of Financial Statements describes a different way Buffett has framed the question, which the authors call the equity bond.
It is a simple idea with large consequences. It explains why durable businesses are so valuable, why the price paid for them still matters enormously, and why patience is rewarded. This article explains the idea, works through the arithmetic, compares it with other approaches to valuation, sets out its limits, and draws out what it means for founders and for anyone buying or building a business.
How a bond works
To understand the equity bond, start with an ordinary bond.
A bond is a loan. An investor lends money to a government or company, which promises to pay a fixed amount of interest each year (the coupon) and to repay the original amount at the end of the term. If you pay $100 for a bond that pays $7 a year, your yield is 7%, and it stays 7% for the life of the bond.
Bonds are attractive because they are predictable. Their weakness is that the payment never grows. Over decades, inflation erodes the value of a fixed coupon.
Shares as a bond with a rising coupon
Now think of a share in a business the same way. The company’s earnings per share play the role of the coupon. Divide them by the price you pay and you get an initial yield, usually called the earnings yield. Buy a share for $20 when the business earns $2 per share and your earnings yield is 10%.
The earnings yield is simply the inverse of the familiar price-to-earnings ratio. A price-to-earnings ratio of 10 is an earnings yield of 10%; a ratio of 20 is a yield of 5%.
The difference from a bond is the crucial part. In a business with a durable competitive advantage, earnings tend to grow year after year. So the “coupon” on your purchase price keeps rising. If earnings grow at 10% a year, the yield on your original price is 10% in the first year, about 16% after five years of growth and about 26% after ten.
Nothing about your original price changes. The business simply earns more on it every year.
Yield on cost
The yield on your original purchase price is sometimes called yield on cost. It is a useful way to see what a long holding period does. Here is an illustration for a business whose earnings per share grow at 8% a year.
| Years held | Earnings growth | Yield on cost if bought at 10% initial yield |
|---|---|---|
| 0 | — | 10.0% |
| 5 | about 47% | about 14.7% |
| 10 | about 116% | about 21.6% |
| 20 | about 366% | about 46.6% |
After twenty years, the business earns nearly half the original purchase price every year. A bond bought at the same time would still be paying its original coupon.
Why this suits durable businesses in particular
The equity bond only works if earnings are both predictable and rising. That is why the idea is tied so closely to durable competitive advantage. A business with erratic earnings has no reliable “coupon”, so the analogy breaks down. A business whose earnings rise steadily for decades behaves like a bond whose payments keep increasing.
This is where the rest of the book’s analysis comes in. Consistent gross margins, modest overheads, low capital needs, little debt, steadily growing retained earnings and strong returns on equity are all evidence that the coupon is reliable and likely to grow. The equity bond is the payoff for all that analysis: it turns a set of financial signals into a way of thinking about return.
Where the growth comes from
Earnings per share in a durable business typically grow for a few reasons:
- retained earnings reinvested at good returns, expanding the business
- pricing power, allowing prices to rise at least with inflation
- volume growth as the business reaches more customers
- buybacks, which reduce the number of shares sharing the earnings
A business that can grow earnings through pricing and modest reinvestment, without heavy capital spending, produces the most reliable rising coupon.
Comparing the equity bond with Graham’s approach
The book contrasts this with the approach of Buffett’s teacher, Benjamin Graham. Graham looked for shares trading well below a conservative estimate of their value, often based on assets, and sold once the gap closed. The return came from the price catching up with the value, a single event.
The equity-bond view is different. It is not about a gap that closes once. It is about a return that keeps compounding for as long as the advantage lasts. That is why Buffett, in the book’s account, became willing to hold excellent businesses for decades rather than selling when they reached a fair price.
Both approaches share one principle: the price paid matters. They differ in what they expect to do the work, a mispricing that corrects or a business that compounds.
Comparing it with other options
The equity bond also gives a natural benchmark. Government bonds are generally regarded as among the safest investments available; Australian Government bond yields are published by the Reserve Bank of Australia. If they pay, say, 4%, then an equity bond with an initial earnings yield of 7% that is expected to grow is a straightforward comparison: a higher starting yield, plus growth, in exchange for business risk.
The book notes that Buffett has often looked at pre-tax earnings when making this comparison, since bond interest is quoted before tax. Whichever basis is used, the point is to compare like with like.
When safe yields are high, the equity bond must offer more to be attractive. When safe yields are low, a lower earnings yield may still compare well. This is one reason share prices in general tend to respond to changes in interest rates.
Projecting the return
The equity bond can also be used to estimate a rough future return. The method is simple, though every input is an estimate:
- Take current earnings per share.
- Project them forward at a conservative growth rate, informed by the business’s history.
- Apply a reasonable price-to-earnings ratio to the projected earnings to estimate a future price.
- Compare that future price with today’s price to estimate an annual return.
An illustration: a business earns $2.00 per share and has grown earnings at around 8% a year for a decade. Projecting 8% growth for another ten years gives earnings of about $4.32. At a price-to-earnings ratio of 15, that suggests a future price of about $65.
| Price paid today | Implied annual return over 10 years (before dividends) |
|---|---|
| $30 | about 8% |
| $45 | about 3.7% |
The same business, with the same future, produces very different returns depending on today’s price. Dividends received along the way would add to both figures.
The price still matters enormously
The most important lesson of the equity bond is that the price you pay sets your starting yield, and you keep it forever.
Take the same excellent business in three scenarios, each with earnings growing at 8% a year.
| Initial earnings yield | Yield on cost after 10 years | After 20 years |
|---|---|---|
| 10% | about 21.6% | about 46.6% |
| 5% | about 10.8% | about 23.3% |
| 3.3% | about 7.2% | about 15.5% |
Every investor owns a great business with the same growth ahead. But the first investor’s yield on cost will always be three times the third’s. A wonderful business bought at an extreme price can produce a mediocre return for a very long time.
That is why, in the book’s account, Buffett has been willing to pay a fair price for an outstanding business, but not any price.
Limits worth remembering
The equity bond is a way of thinking, not a formula.
Growth is an estimate. Past growth does not guarantee future growth, especially if the advantage weakens. Conservative assumptions are safer than optimistic ones.
Earnings are not cash. Earnings that must be reinvested just to stand still are not truly available to owners. The equity bond works best with businesses whose earnings closely match their owner earnings.
Interest rates move. The attractiveness of any yield depends on what safer alternatives pay.
Advantages erode. A business can look like a rising bond for years and then, through technological or competitive change, stop growing. The equity bond has no maturity date and no promise of repayment.
The price-to-earnings ratio at the end is uncertain. Projecting a future price requires assuming how the market will value the business, which can change substantially.
What this means for building a business
For founders, the equity bond offers a useful way to describe what makes a business valuable: not just the profit it earns today, but the likelihood that its profit keeps rising on the same capital base for many years.
Designing for that means:
- lasting customer need, so the coupon keeps being paid
- low reinvestment requirements, so earnings are genuinely available
- pricing power, so the coupon rises with inflation and beyond
- consistency, so the coupon is predictable enough to value
A business with these qualities is worth far more than its current profit suggests, because buyers can see a rising stream of earnings ahead.
Buying a small business
The same idea applies to buying a small business. A business priced at three times its annual profit offers an initial earnings yield of about 33% before considering the owner’s own labour. That sounds generous, but small businesses often carry high risks: dependence on the departing owner, a few large customers or a single location. A higher yield is compensation for those risks.
The equity-bond question remains useful: how reliable is this coupon, and is it likely to grow? A business with modest but steady, growing earnings may be worth a higher price than one with larger but erratic earnings.
A worked example
Two people each invest $200,000. This is an illustration.
The first buys a small, established bookkeeping practice earning $50,000 a year after paying a market wage for the work, an initial yield of 25%. Client retention is high, fees rise steadily with inflation and the practice grows modestly through referrals. Over ten years, earnings rise to around $80,000, a yield on cost of 40%.
The second buys a trendy café earning $70,000 a year, a 35% initial yield. Competition intensifies, rents rise and earnings fall to $30,000 within five years.
The café looked like the better deal on day one. The bookkeeping practice was the better equity bond, because its coupon was reliable and growing.
The equity bond and inflation
The equity bond has one more advantage over an ordinary bond that is easy to overlook: its relationship with inflation.
A fixed coupon loses purchasing power every year that prices rise. Over twenty years of moderate inflation, the real value of a fixed payment can fall by a third or more. A business with genuine pricing power, by contrast, can usually raise its prices at least in line with inflation, so its earnings, and the coupon they represent, tend to keep pace.
Not every business can do this. Those competing mainly on price often find that costs rise faster than they can lift their own prices, squeezing margins in inflationary periods. The businesses the book favours, with strong brands and loyal customers, are better placed to pass costs on. That is one more reason the equity bond suits durable businesses in particular: their coupon is protected against one of the main risks that erodes bond returns.
Common mistakes
Focusing only on today’s earnings. Growth and reliability matter as much as the starting figure.
Projecting optimistic growth. Use history and caution.
Ignoring price because the business is excellent. Price sets the yield forever.
Treating erratic earnings as a coupon. The analogy only holds for predictable businesses.
Forgetting the alternatives. Compare with what safer options pay.
Questions to ask
- What is the current earnings yield, and how does it compare with safe alternatives?
- How reliably have earnings grown over the past decade?
- How much of those earnings must be reinvested just to stand still?
- What would the return be under conservative growth assumptions?
- For your own business: is your profit a reliable, growing coupon, or a fluctuating one?
Bringing it together
The equity bond reframes a share, or a whole business, as a bond whose coupon grows. For durable businesses, earnings rise year after year on the same original price, and the yield on that price climbs steadily. That explains why such businesses are so valuable and why patient ownership is rewarded.
But the price paid sets the starting yield, and it can never be changed. A great business bought too dearly can disappoint for a very long time. The equity bond, in the end, is a lesson in both quality and discipline.
Source: Mary Buffett and David Clark, Warren Buffett and the Interpretation of Financial Statements (2008). Figures in this article are simple illustrations, not data. This article is general information, not financial or investment advice.
