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All right, let's talk about something that gets to the absolute core of value investing. How can you, as a smart investor, justify paying what looks like a really high price for a truly exceptional business? We're going to dig into a master class on this exact problem using an incredible real world example from the legendary investor Joel Greenblat.
So, here's the central puzzle we're trying to solve today. When on earth is paying 21 times earnings considered cheap? I know, I know. For any of us with a value bent, that number just screams expensive. But as we're about to see, that simple PE ratio, it almost never tells the whole story. Here's how we're going to break it all down.
First, we'll set up the problem with our main case study. Then, you know, we'll go learn from the master, Warren Buffett, to get a solid benchmark. After that, we'll uncover the two big clues, something called the ROIC premium and the huge impact of interest rates. And finally, we'll pull it all together to see what the value investors real.
Okay, so our story kicks off in the year 2000. We're looking at a company that had just been spun off from its parent, Moody's Corporation, Ticker MCO. Greenblat and his team took a look and they saw something really, really special. But they also saw one huge problem. Now, you look at this business on paper and it's pretty much perfect.
Moody's was a fresh spin-off, which is a classic hunting ground for value investors. It was in a duopoly with S&P, meaning they basically owned the credit rating industry, each with about 40% of the market. And get this, it had been growing its operating profits at 17% a year for almost 20 years. The barriers to entry were a fortress.
You can't just wake up and decide to be a ratings agency. You need a reputation built over decades. It was without a doubt a phenomenal business. The only catch, the price. It was trading at 21 times what they expected it to earn next year. Ouch. So, what do you do? How do you even start to think about a price like that?
Well, Greenblot's team did something brilliant. Instead of comparing it to other lesser companies in its industry, they decided to look for a precedent. They looked for an example of a master investor buying a great business. And they landed on Warren Buffett's iconic 1988 investment in Coca-Cola. Buffett buying Coke.
I mean, it's the stuff of legend, right? Back in 88, he paid around 15 times what it had earned in the past year for a business with one of the world's most powerful brands, incredible returns, and a moat you couldn't get across. And by the year 2000, when Greenblat was looking at Moody's, that investment was up 10fold.
A 23% compound annual growth rate. This this was the gold standard. This was the benchmark they were going to use to measure the Moody's opportunity. So, you put the two deals side by side, just looking at that simple PE multiple, and the problem just jumps right off the page. Moody's looks way, way more expensive.
Buffett got Coke for about 13 times forward earnings. Greenblot was looking at paying 21 times forward for Moody's. On the surface, it just doesn't seem like it's in the same league. But this this is where the deeper analysis, the real work begins. The first clue to cracking this case is a concept that is just absolutely crucial for valuation.
Return on invested capital or ROIC. See, it's not just about how much a company earns. It's about how much money it has to plow back into the business just to generate that growth. Okay, here's the difference in a nutshell. Coca-Cola, as great as it is, needs a lot of capital. To get its 12% growth, it had to reinvest about 20% of its profits every year into things like bottling plants, trucks, and marketing.
Moody's though, it was what Greenblood's partner called some guys in a room with computers. It needed almost zero new capital to grow. Its biggest asset was its name, its reputation. So, what does this mean in real money terms? It means for every single dollar of profit that Coca-Cola reported, only 80 cents was actual spendable free cash flow that could go back to the owners.
The other 20 cents had to get put right back to work just to keep the engine running. Moody's, on the other hand, was a completely different animal because it needed basically nothing to grow. For every dollar of profit it reported, the whole dollar, all 100 cents, was free cash flow that could be given back to shareholders.
This is huge. It means a dollar of Moody's earnings was just fundamentally more valuable than a dollar of KO's earnings. Okay, let's attach some numbers to this idea. We start with Buffett's baseline. He paid 13 times Ford earnings for Coke. Now, since Moody's earnings are about 25% more valuable because you get to keep all of them, we can justify paying a premium for that.
So, Greenblood's team figured, hey, we can pay a multiple of 15X. So, just by adjusting for this one factor, capital efficiency, we've already closed the gap from 13x up to 15X. But hold on a second. We've only justified paying 15 times earnings. The stock is still sitting there at 21 times. So, this first adjustment, as important as it is, doesn't get us all the way home.
There's got to be another piece to this valuation puzzle. What are we missing here? And that brings us to the final and maybe the most powerful clue. It comes from stepping back and looking at the big picture, the macroeconomic environment. Specifically, we're talking about interest rates, which are basically the foundation that all valuations are built on.
I mean, just look at this difference. When Buffett bought Coke back in 1988, the 30-year US Treasury bond, you know, the risk-free rate was paying you about 9%. Fast forward to 2000 when Greenblat's looking at Moody's, and that same bond is only paying 6%. That's not a small change. That fundamentally changes the entire game for investors.
And here's the key insight. Interest rates had dropped by almost 40% between these two moments in time. Now, think about what that means. The risk-free rate is what you use to discount all future profits back to today's value. So, a lower rate makes a whole stream of future earnings way, way more valuable in the here and now.
And this this is the moment of revelation when you combine our first adjustment for how efficient the business is with this second adjustment for interest rates. The whole picture just snaps into perfect focus. Okay, check this out. This is how the math just beautifully resolves the whole puzzle. You take that ROIC adjusted PE of 15 that we already said was fair.
Then you adjust it for that 40% drop in interest rates because valuation multiples and interest rates move in opposite directions. A lower rate means you can justify a higher multiple. That 40% drop justifies about a 40% premium or a 1.4 factor. And what happens when you multiply 15 by 1.4? You get exactly 21.
All of a sudden, that 21 times Ford PE that looks so crazy is perfectly justified when you compare it apples to apples with one of the greatest investments ever made. So, what's the big lesson here? What can we all take away from this amazing piece of financial detective work? Cuz this isn't just some old story.
It gives us a powerful practical framework for how to think as investors today. Okay, here are the big takeaways. First, real value investing isn't about just finding low PE stocks. It's about figuring out what a business is actually worth. Second, the quality of the earnings is everything. You have to ask how much cash do they have to spend to get their growth.
Third, you can't invest in a vacuum. The macro environment, especially interest rates, sets the playing field for all valuations. This means a high PE can absolutely be justified for a fantastic capital light business, especially when rates are low. And what it all comes down to is this. Your real edge comes from deeply, deeply understanding the business you're buying.
This quote from Joel Greenblat himself just says it all, doesn't it? It's not just the number they report on the income statement. It's about the cold, hard cash you, the owner, get to put in your pocket while the business still keeps growing. That right there is the secret sauce of a great business.
And that really brings us to the final thought. This whole analysis, as brilliant as it is, was for a situation back in the year 2000. It gives us a way to think, not just a formula to copy and paste. So the real question it leaves for all of us is this. If we use these same principles, thinking about capital efficiency and thinking about the world we live in today, what great business is the market getting wrong right now? That's the challenge.
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