Cost of capital: a concept massively misunderstood
Updated: Dec 29, 2020
We all have been taught about the cost of capital during some stage of our lives.
You use the concept of cost of capital to evaluate decisions such as:
- Buy a car vs hire Uber
- Buy a house or rent
- Worth of a company
- Bond valuation
- Project evaluation
Most of the finance professionals have been taught to calculate the cost of equity using Capital Asset Pricing Model (CAPM) and the cost of debt as risk-free rate plus a credit spread.
Cost of equity = Risk-Free Rate + Beta X Market Risk Premium
Cost of debt = Risk-Free Rate + Credit spread
(I will not bother to explain these terms, read any finance book to know more)
I also applied the same for many years, especially during management consulting days. I still remember long debates with clients on cost of capital to be 8.5% instead of 9% and so on.
Later, I started my investment firm. A 0.5% difference can cause a huge difference in the valuation.
Terminal value = Free cash flow / (Cost of capital – growth)
Let’s assume free cash flow as 1000 and growth at 4% and see the difference.
Terminal value = 1000 / (8.5%-4%) = 22,222
Terminal value = 1000 / (9%-4%) = 20,000
A difference of 2,222 can be huge, depending upon the context.
How can you base your investment decisions on such a wide range? It was puzzling, but each time I read a book on this topic it would point towards Capital Asset Pricing Model, multi-factor model etc.
I knew something was wrong but was not sure what was right. Then I started reading Warren Buffet’s letters to shareholders, available for free on Berkshire Hathaway website.
I refer to Bhagavad Gita for any answer on human life and psychology and I refer to those letters (It’s like Gita for investment professionals) for any answers on investment-related issues.
“Cost of capital is what could be produced by our 2nd best idea and our best idea has to beat it.” – Warren Buffet
Buffet does not believe in the academic style cost of capital. Look at the second-best alternative and that should be your discount rate. He discounts cash flows at 30-year government bond yield because he sees at the longevity of those cash flows and businesses for that long.
What is the cost of equity that can be used to discount Indian companies?
A bank deposit. Readers who are financially inclined, a 10-year government bond yield.
Businesses that have predictable cash flows can be discounted at a 10-year government bond yield.
I use the cost of equity-based on the quality of business and predictability of the cash flows.
“Think of three types of ‘savings accounts.’ The great one pays an extraordinarily high-interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.” – Warren Buffet
Great business: High Return, High Growth
Example: Asian Paints, Nestle India
These businesses have a predictable cash flow. The risk attached to the cash flow is minimal. The cost of equity can be 10-year government bond yield.
Good business: High Return, Low Growth
Example: Motherson Sumi, Symphony
These are good businesses but cash flow is less predictable. I use 4% more than the discount rate I use to discount cash flows of a great business.
In the current interest rate environment, I use 10% as the cost of equity for such businesses.
Gruesome business: Low Return, Low Growth
Example: Airtel, DLF
Why even bother about these businesses. But if you were to discount, the range of cost of equity maybe around 12-15%, depending upon the nature of business and predictability of cash flows.
The capital structure may include debt as well. You can look at the recent borrowing by the company and use that as a proxy for the cost of debt. Apply relevant weights based on the capital structure, and accordingly come out with the cost of capital.
I prefer having a range rather than airtight numbers. Here is the reason why:
Throughout my life, I have been an above-average mathematics student. During school days, I had a hobby of coming up with difficult questions (for my friends who were preparing for IITs etc.) and then solving them. During the 12th class exam, I was done with the maths exam in 1 hour (instead of 3), still got full score.
What does this mean? After many years, I realized that due to this deep inclination towards maths, I was looking for precise answers.
Here is a funny breakthrough moment. Two years back, I attended ‘Judo Gyan’ session at Shiv Nadar School for my son who was in Nursery class.
The teacher said “number on its own is meaningless if we can’t associate the number with the sense of quantity’.
That was my moment of self-realization. We are looking for too precise an answer but valuation is a broad range and often in a continuum.
If you incorporate a sufficient margin of safety, the probability of success is high.
The game is not to win always but rather the number of wins to be higher than the number of losses. It’s that simple.
You are just trying to increase your odds to win.
Understanding competitive advantage, business model, management quality etc. are all qualitative assessment. However, these aspects contribute way more than the precise number of cost of capital.
“It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books, so there’s a lot of twaddle and fuzzy concepts that have been introduced that don’t add much.” – Charlie Munger
Charlie Munger and Warren Buffet could not get their precise understanding of the right ‘cost of capital’. What makes you believe that you or I can.
I have made a broad cost of capital range depending upon the quality of business. You can come up with your own version.
Live with the imprecise version of life and valuation, it’s worth it.
The information contained on this website and the resources available for download through this website is not intended as, and shall not be understood or construed as, financial advice. You should consult with a financial professional to address your particular information.