How Should We Calculate The Cost Of Capital?

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During his recent interview with Tobias, Michael Mauboussin, the Director of Research at Blue Mountain Capital Management, discusses how we should consider calculating the cost of capital. Here’s an excerpt from that interview:

Tobias Carlisle: There’s a few questions that fall out of that for me. When you’re thinking about cost of capital, are you calculating that in a traditional, efficient markets, looking at the beta of the stock? Or how should we be calculating the cost of capital?

Michael Mauboussin: It’s a great question, and we’ve written a bit about this, and I’m completely familiar, and to some degree sympathetic, to some of the charges against that traditional way of doing it. There are a lot of adjustments you can make, for example using industry betas versus firm-specific betas, and some regression techniques to allow you to get to a slightly better place. But I also say you should triangulate. The bottom line I always say, I say this to my students in particular, you’re a business person, so forget about formulas and filling out formulas. Think about this as a business person. And you have a couple things you can do.

Michael Mauboussin: One is, you have, for example, the credit markets. You have bond yields. That should be a touchstone. You have options markets. Options markets can give you some sense of what’s going on, so you have other comparable things. In other words, there should be ways to triangulate to get into something that’s intelligent. Then you want to just make sure that you’re consistent, so if it’s an expectations game, that consistency becomes very important. So it should pass, I always say, whatever the cost to capital you come up with should make business sense, it should make common sense to some degree, and of course you want to have it tied to some degree to principles and finance. But the notion of starting building with a risk-free rate and adding some sort of excess risk premium, that probably does make sense. But you’re right, we try to have it both ways, which is using a traditional asset pricing model, but also understanding that that’s not the end-all, be-all, and certainly don’t do that by rote. It should be thoughtful, and understanding the adjustments that will get you closer to where you think you should be in terms of the real world.

Tobias Carlisle: I’ve tried to understand, in some of Buffett’s writings, he writes about, he just says if you reinvest over a period of time and you find that you’re trading at a discount to book value, for example, then that’s an obvious example of where the reinvestment is turning a dollar of earnings into 50 cents, or less than a dollar of retained value, and vice versa. Is that an overly simplistic way of going about it, or do you think it’s an effective …?

Michael Mauboussin: I’ve actually opened a number of my reports with that basically dollar-bill test, and that makes some sense. If you’re earning exactly your opportunity cost, and you invest in your business your dollar should be worth a dollar on the marketplace, and so that’s one times book, that does make some sense. And of course if you’re earning high returns, if the value of that stream of cashflows then becomes more than a dollar, and as you mentioned below a dollar, it should be less than a dollar. So at least as a simple framework I don’t think that’s a terrible place to start.

Michael Mauboussin: The devil becomes in the details in terms of how the real world works. It’s often that even businesses that are valued … I mean there are a whole slew of issues with book value to begin with, but even simplistically, companies that even are value-neutral, value-destroying, often trade at a premium to book value, I think because they have embedded options for restructuring. So it’s very tricky to map that one-to-one from theory to the real world, but I think as a conceptual way to think about it, it absolutely makes sense, yeah.

You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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