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No. of Recommendations: 5
You are welcome, Pedro.

In other words, cost of equity is somewhat equivalent to asking "why should I invest in this company rather than just buying a T-bond?"

Yes. Whenever you are thinking of becoming an owner, you want to compare your expected return to the risk-free rate, whose proxy is the U.S. Treasury (if you are a U.S. citizen). If your expected return -- your cost of equity -- isn't sufficiently adequate, then why bother becoming an owner.

If you read the various MF boards you will find that different people use different cost of equity figures.

My approach, as mentioned, is to use the yield of the 10-year Treasury and then add 500 basis points. Going back to the late-1920s, the market has demanded a 500 basis point spread margin of safety, based on the research that I have seen.

Tonight, the 10-year yields 3.58% (a good source is Bloomberg http://www.bloomberg.com/markets/rates/index.html). So my cost of equity should be 8.58%. But these low yields may not last, which is why I will bump my cost of equity up to 10%.

Books have been written about how to calculate the "correct" cost of equity. But whose to say my number is better than yours, or vice versa.

The key thing is to discount a firm's future earnings by your minimum required rate of return, and then buy at a big discount to intrinsic value. If I think a company has a chance of growing five-fold in a decade, my maximum price-intrinsic value is 65%. If the business has more of a value profile (authentic earnings power but no Earnings Power Staircase; to learn more see www.EarningsPower.com), then my maximum PIV is 50%.


Hewitt
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