Get to the broad range of Cost of capital
Updated: Aug 9, 2021
Most finance professionals have been taught to calculate equity using the Capital Asset Pricing Model (CAPM) and the cost of debt as a 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
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 the Berkshire Hathaway website.
“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 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. For 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.
The discount rate is based on the quality of business and the predictability of the cash flows.
“Think of three types of ‘savings accounts.’ The great one pays an extraordinary high-interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will also be earned 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 a 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 the cash flows of a great business.
I use 10% as the cost of equity for such businesses in the current interest rate environment.
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 may be 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.
“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
Based on the quality of business, a broad range of cost of capital can be worked out.
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