Apple Juice Investing: Do You Know Your Cost of Capital?

The Discounting Rate or a 'Cost of Capital' is often a very important input in any kind of Valuation model, including Equity Valuation models. But do you know the Cost of your Capital?

One of my most favorite articles related to Finance comes from the Harvard Business Review (July-August, 2012 Issue): Do You Know Your Cost of Capital? by Michael T. Jacobs and Anil Shivdasani. The article argued that the CXOs and decision makers of a business do not have a clear idea of what Cost of Capital means. In being so, they either execute projects they should have rejected or reject projects that could have added value to them. This, they said, cost the economy a lot of money.

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Recently on Quora, someone asked me how I use Discount Rates in a DCF Valuation. This immediately reminded of the above mentioned HBR article. Considering the several other theories and opinions I had come along the way since my first reading of that article, here's what I had to say finally:

Both Warren Buffett and Charlie Munger, have stressed on the importance of ‘Opportunity Cost’ in Investing.

Here’s what Charlier Munger had to say on one particular occasion:

“The trouble isn’t that we don’t have a hurdle rate – we sort of do – but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly. It’s like the mail-order-bride firm offering a bride who has AIDS – I don’t need to waste a moment considering it. Everything is a function of opportunity cost.”

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You see, the concept of an Opportunity Cost is very easy to understand. It’s arriving at that specific number that’s difficult. In a crude sense of the word, an Opportunity Cost is your ‘next best option’.

Imagine that you just purchased a bottle of apple juice for Rs. 100 during a particularly hot day.

Here, let’s make the simplifying assumption that you are not really bothered about its utility (Quenching your thirst), but bought it because you felt like it. You are walking down the street and you are confronted by a stranger who’s visibly very thirsty. He looks like he needs the bottle of apple juice more than you. He pleads you to sell him the bottle for Rs. 105. You don’t react at all. He raises his offer to Rs. 110. You’re still not convinced. He says finally, fine, sell it to me for Rs. 120. Something clicks in your head and you think “Well, that’s a good deal”. In this case, the Rs. 20 or 20%, was your implied Opportunity Cost: the minimum percentage returns you think would convince you to transact.

In a similar vein, Charlie Munger once talked about how Warren Buffett got an investment deal from an Emerging Nation company. He passed on it, saying “I would rather add to my position in Wells Fargo.”

So, in that case, Warren Buffett considered Wells Fargo his weakest investment and used that as his anchor for new investments. His Opportunity Cost was probably what returns he thought he would earn from holding on to Wells Fargo for several years.

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So there are two ways in which to arrive at the Discounting Rate for an investment:

Ask yourself “What percentage returns would I be happy earning over X years?”

Although this seems elementary, I am confident that this is as close as you can get to figuring out your true Opportunity Cost. Logic should tell you that you should demand something in excess of the Risk-free Rate, which in most cases is the long-term Government Bond Yield. Here, let’s quote Mr. Buffett again, because why not:

“We just try to buy things that we’ll earn more from than a government bond – the question is, how much higher?”

How much higher, again, is completely left to you. You could maybe look at the long term historical returns on your country’s famous indices (Like the S&P 500 or the NIFTY 50 for Equities), for example and consider demanding a little in excess of that. You could consider demanding something above the long term performance of Equity/Debt Funds in your country. If you are an expert investor, you might want to demand way in excess of all of this. The idea here being, you should mentally make a decision on what your ‘next best investment option’ is and what kind of guaranteed returns that option is likely to provide over a given number of years.

In the end, the Discounting Rate should be the number that immediately pops up in your head when you ask yourself the question. It’s that simple. The number keeps changing over time, of course, and your valuations should reflect that. But also be aware that nobody, not even Warren Buffett, can continue earning extraordinary returns over the very long term. So, if your near-term expectation of returns are excessive, consider moving it ever so slightly towards the Risk-free Rate for any discounting to be done beyond 10–15 years.

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The second way is to ask yourself “What’s the weakest Asset in my portfolio and how much will that Asset earn over X years?”

This is arguably more difficult, because you need to make an estimate of what is the weakest Asset in your portfolio and what returns that Asset would earn over a given number of years.

For Equities, you could start by making assumptions of Sales Growth, Margins and Reinvestment for all your holdings. This should show you how the Return on Equity of all your holdings will evolve over time (According to you). So logically, the lowest Return on Equity CAGR in your portfolio should be your anchor for future investments. Then, borrowing words from Mr. Munger, you could justify your action:

If I know I have something that yields 8% for sure, and something else came along at 9%, I’d consider selling what I hold and buying the new one.

If you are uncomfortable making projections, then taking a leaf out of Warren Buffett's line of thought, an alternative question could be "Would I be more comfortable holding Asset X or Asset Y?" and a decision based on the answer. But be warned that getting an intuitive answer to that question takes years of time in the market and watching several economic cycles destroy and pump up your wealth. After all, Warren Buffett is the Yoda of the Stock Market. Few can match his level of intuition when it comes to investing in Stocks. If you think you're there, go ahead.

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Exhausted yet? Worry not. Here's a nifty tool I made which may make things a little easier (Follows the logic of Question #2 above):

(Download Apple Juice Investing - Personal Cost of Capital Calculator for Equities)

All you need to do is enter a few simple numbers and the model throws out a range of possible returns. Then, based on your idea of how much the selected Metric's Growth Rate will be and the Terminal Metric value, you should be able to arrive at your personal Cost of Capital for that specific investment.

For example, here, I've entered the details for Cera Sanitaryware. Conservatively, I can state that Cera's profits can growth at at least 15-20% for 30 years and after that, have a Terminal P/E of at least 20. That would put my personal Cost of Capital for giving up on Cera at 13-18% or so.

But the idea is to perform a similar analysis for all the stocks you hold and turn up with the least amount of expected returns. This percentage will then become your personal Cost of Capital, as far as equities are concerned. You can also easily understand how this Cost of Capital is prone to periodic changes, as I'd mentioned earlier.

Really though, the first method is far simpler, logical and personal.

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With all that said, I still feel like there are some loose ends I would like to address:

1. I generally don’t use the CAPM or arrive at a WACC using a similar method. WACC is useful as a hurdle rate for companies. The CEO, who decides on new investments thinks for the company—indeed, he thinks for millions of people around the world. So it would make no sense for him to ask the above questions. Therefore, using a scientific method to arrive at a WACC is the most logical course of action for the CEO (We could argue days on end about whether the Five-factor Model is better than the CAPM or not). Similarly, it would make no sense for an individual investor to consider using the WACC, because an individual investor thinks only for himself and not for millions of people around the world. In essence, the CAPM generalizes Risk. However, Risk is very, very personal. In fact, it’s my humble opinion that we haven’t even scratched the surface with understanding Risk. The article Averse to reality by Nobel Laureate Dr. Richard Thaler should be a good starting point for you to understand what I’m trying to say.

2. If you are adamant about using the CAPM to arrive at the Cost of Capital, use the Bottom-up Beta-based CAPM instead. It solves at least one problem with the CAPM—Specific Financial Risk.

3. Do You Know Your Cost of Capital? is a wonderful article by the HBR that glances over how one could arrive at a near-perfect Opportunity Cost for an investment. It involves too many moving parts in my opinion, but hey, incremental knowledge never hurts.

4. Buffett FAQ is a treasure trove of what Warren Buffett and Charlier Munger have ever said about Investments and Valuation. You might very well find a better answer than mine in there.

5. When in doubt, use a Margin of Safety. Demand 3% extra. Demand 5% extra. Demand 10% extra. Discount like nobody’s watching.

6. Consider visiting my earlier blog post Numbers and Narratives: A Simple Discounted Cash Flow (DCF) Model for Equity Valuation. It’s a free DCF Model for Equity Valuation that comes with 4 types of Discounting Rate options: the Risk-free Rate, CAPM-based WACC, Bottom-up CAPM-based WACC and Opportunity Cost. Of course, some inputs are required on your part. Read through the post to figure out how to use the model. The model has changed a bit since I made the original post and I’ve re-uploaded it, but you should be able to navigate through the model without much difficulty—it’s user friendly. This is the model I use to Value my prospective Equity Investments.

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I'm curious - do you know your Cost of Capital? How do you arrive at it? Do you use any of the methods mentioned in this post? Do you have a different method? Discuss away in the comments.

Disclaimer: I hold Cera Sanitaryware in my portfolio. My views may be biased.