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No. of Recommendations: 9
My two cents here: the cost of equity is whatever expected return you need in order to be induced to purchase a particular company's stock. So, like abstract art, your opinion of what a firm's shareholder interest rate is may differ from mine. But this is okay...varied estimates is what brings buyers and sellers together.

When I started writing the book in 1995, I worried whether I was using the "correct" cost of equity. But then as I gained experience, I realized the key thing is to recognize that equity has a cost, however subjective that number may be.

From time to time I will study a company that cost stockholders lots of money. This is a variation of Charley Munger's quip that all he wants to know is where he's going to die, that way he'll never go there. With stocks, I want to know if the Earnings Power Chart would have kept me away from Krispy Kreme and other major-league wealth destroyers. (Click here for complete list: http://www.earningspower.com/canary.html

In most instances, either or both alternate P&L's are better leading indicators of trouble. And when the enterprising income statement is the coal mine canary, it generally doesn't matter what cost of equity figure you use, the company still loses money.

By the way, determining whether a company is profitable on a defensive and enterprising basis is just part of your analysis. You also want to compare these profits (loss) figures to accrual earnings to see if there is a "tight" or "loose" fit. The tighter the fit, the better. And be sure to look at the trend in defensive and enterprising profits over the last, say, five years. If accrual profits are rising but defensive and/or enterprising profits are falling, this is a classic red flag. At the very least, see if you are able to determine why the earnings figures are going in opposite directions.

So, figure out a way to determine a firm's cost of equity that makes sense to you. But don't lose the forest for the trees. As Warren Buffett teaches us, "It is better to be approximately right than precisely wrong." In other words, give as much thought to the sustainability of a firm's competitive advance as you do to the capital asset pricing model.

Thoughtful commentary by everyone!


Hewitt
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