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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 214545  
Subject: Re: Influence on ROE in Investing returns Date: 10/11/2012 10:51 AM
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I inferred from the above that:
* when you suggested Siegel's constant as a sanity check
* and Siegel's constant happens to be 6.5%
* and you then made reference to WACC's 6.5% above inflation

that you meant a sanity check on WACC would be Siegels constant + inflation.


Ahh, interesting viewpoint.
I am hoist by my own petard.

The thing about WACC is that, like intrinsic value, it's really important
and hard to calculate. Some people have come up with very specific ways
of calculating it but I don't buy those much.
So, though I know it's important, I don't really know how to estimate it well.
I have never spent a lot of time estimating it and thus don't know my own mind on this.
In short, I've never really thought about the issue of whether WACC
is best thought of as a nominal or a real rate.

On general principles the only WACC that is useful is both forward looking and cylclically adjusted.
The rate this year isn't really the one that counts.

The main starting place for me is debt, which is obvious.
When inflation is high, corporates will be paying higher nominal interest rates.
Without a doubt, the cost of debt for a company is best thought of as a margin above inflation.
So the first linen of thinking is this: in an inflationary year the
nominal cost of capital will be higher therefore the nominal return on
capital had better be higher to match, so a constant ROA above a
rising WACC will be a bad thing.
But maybe this isn't an issue: capital (debt, anyway) is constantly
renewed, so the cost of capital rises and falls in nominal terms
over time with inflation rates, though with a little lag.
So the gap between them (which drives profit) will stay relatively
constant in the natural course of things.

I dunno. I'm going to have to think about this some more.
It seems to me the only cost of capital that matters is the real cost per year averaged over the next 5-15 individual years.
(not a rate of change between two times, but the time weighted average
of many individual rates, each of which is a real rate in a one-year interval).
But perversely it seems to make sense to me to compare this to the
current nominal ROA because the ROA will generally not change with inflation.
To a first approximation, nominal revenues rise with nominal costs and the gap stays the same percentage.
So I've led myself to the odd position of thinking that it actually makes sense to compare a nominal rate to a real rate.

Jim
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