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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 210342  
Subject: Re: Influence on ROE in Investing returns Date: 10/8/2012 5:40 PM
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Going back to another point you have made in the past about requiring
ROE to be greater than the cost of capital. Is there a generally
accepted figure for the weighted average cost of capital over time?


This is a very contentious subject. Translation: I think everybody
else is an idiot, meaning I'm probably the one that is off base.
There are standard formulae for calculating this but they seem utterly absurd to me.
Berkshire's cost of capital has nothing to do with its share price or volatility thereof.

The starting point is fairly simple.
If your company valuation is low you use debt and the cost is the
interest rate you pay, and if your valuation is high then you use equity and
the cost is some estimate of the forward+cyclically adjusted earnings yield.

I look at what capital the firm really is deploying (if any) or might
soon deploy, and where it's really coming from.
If they aren't deploying any new capital, then the answer is "N/A".
If they aren't raising any equity then the equity isn't an input.
If they use debt, that's the only thing I look at.
It's only if they are using internally generated capital that it gets tricky;
if you have a productive cash cow division bought many years ago at a basis that
is a long-ago sunk cost throwing off cash, what's the cost basis on that money really?
Berkshire's WACC might be well under 2% on this view, the only
notable exception being the equity issued for part of BNSF which was quite pricey.
Equity was issued at about 1.18x book (yes, that's all). If you
assume that the valuation stays the same then both book and price are
rising on trend at around 9%/year so you could think of that as the cost.
Maybe bump that up a couple/few points based on normalized valuation levels.
Actual borrowings are in the 1-3% range these days, and float has a negative cost.

About the only way in which I agree with standard practice is that
WACC is a very company specific thing, so there isn't any good
rule of thumb unless you're talking about the market-wide average cost.
Globally speaking across all equities the average cost of capital is
axiomatically equal to the average return on capital in equities averaged over time.
That should provide a good sanity check, since the cap-weighted average of
the WACCs you estimate should come close to Siegel's constant for the US.
That's again contrary to theory, as most MBAs will come up with much
higher WACCs than 6.5% above inflation.

Jim
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