Musings On The Cost Of Capital, With Advice From Buffett

I attended the Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) meeting in May this year and was interested to hear Mr. Buffett and Mr. Munger briefly discuss their views on the cost of capital. I laughed heartily at Mr. Munger’s dismissal of the ‘MBA definition’ of same. I have been thinking about a sensible way to view the cost of capital and its consequences on business valuations for a couple of years and coming home from Omaha I thought I would try to tie some of the concepts together coherently; this article is the result. Expounding a thought process like this is, for me, an excellent way to learn and refine one’s thinking – and I would enjoy any feedback from those with contrasting and similar views.

Phrases like ‘consistently generates returns in excess of its cost of capital’, the analyses of companies’ cost of capital via the capital asset pricing model (CAPM), and valuations reliant thereon, are ubiquitous throughout sell-side reports. I want to deal with: from a CEO‘s or Board’s perspective, what is the most sensible way to think about cost of capital; and from an analyst’s perspective, how best to think about valuations using this new paradigm?

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I don’t buy into how some business executives think about the cost of capital; that is, if their companies’ corporate presentations / investor communications are indicative of how they actually view the concept. When a CEO sits down to consider an investment opportunity, what should dictate whether or not she allocates capital to it, and how much capital to employ? In other words, what exactly is her cost of capital, when it comes to a capital allocation decision?

In my opinion, if the manager uses the following simple definition, the owners of the of the business’ capital will be more than satisfied, over time.

A business’s cost of capital is the return that can be generated by employing incremental capital in its collective next best idea / investment opportunity on a risk-equivalent basis.

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