The cost of equity as defined by Investopedia is “the rate of return an investor requires from an equity investment for it to be considered worth the risk”. The cost of equity is calculated as the sum of the risk free rate and the stock’s beta multiplied by the equity risk premium (see image below for the formula in full).

In valuing companies, you would typically use this formula along with the cost of debt to find the weighted average cost of capital, WACC. It is an immutable fact that the present value of a business is the future cash flows of said business discounted to today using an appropriate discount rate. The appropriate discount rate just so happens to be WACC in most cases.

I have a few problems with using WACC as a discount rate. I’ll explain why:

I am sure most people have heard that volatility is an ineffective measure of risk. I agree with this statement. I am of the opinion that the only way to measure business risk is to avoid numeration almost entirely. The only way to think of risk is to identify the innate risk of the business operations and the resulting probability of permanent capital impairment. To be succinct, I do not believe the cost of equity is of any use in discounting cash flows. Since all public equities have a positive current equity value, this means I cannot support a weighted average cost of capital either.

On the cost of debt…

Of the make up of WACC, the cost of debt is the more coherent of the two. It makes sense that all else held constant, incremental debt up to a point is beneficial to a firm’s value, as it decreases the WACC. This is because the interest payment on debt is tax deductible (avoiding taxes can be quite beneficial, just ask John Malone). But again, I don’t think the assigned cost of debt is all that useful in valuation. I’ll explain how I like to think of it down below:

Opportunity Cost

All economic decisions should be measured against ‘the next best alternative action’, the opportunity cost (as defined by the Core Economics textbook). The same textbook also defines the opportunity cost of capital to be: the amount of income an investor could have received by investing the unit of capital somewhere else. I think that is a perfect definition and the best way to think about discount rates. Every time you choose to deploy capital into a business or something else there is always the chance to refrain from doing so and just put it into a risk-free asset.

Add: When I mention risk-free rate (or asset) what I mean is the long-term yield on a government bond

I think the best measure of a discount rate is simply the prevailing risk free rate (or if abnormally low, an adjusted amount closer to the long-term average risk-free rate – being careful of attempting to predict future interest rates/yields…). By comparing the yields between your potential investment and the risk-free rate you are addressing the opportunity cost of capital. The investor should then be able to judge the margin of safety as the excess of a firm’s yield over that of the risk-free rate for the same length of time. I believe the surer the business the lower the excess on yield is needed is to be acted upon, the opposite holds. It is important to note that price paid per-share will undoubtedly have an impact on the return of the investment as it is the denominator of an earnings yield.

The reason terrific businesses can justify being bought at higher prices (consequently lower yields) is due to the durability of their earning power. Over the long-term, businesses that have durable advantages over competition will grow their earnings and yield. The best of businesses can justify narrower margins of safety but the examples of such businesses are far and few between.

Assumptions

I made a key assumption in writing this post that the investor is able to ‘confidently’ forecast future cash flows. If one is not confident of doing so, there is no point comparing the opportunity cost and they should just move on. Some would argue that you should adjust the discount rate higher to make up for the uncertainty or extra risk of the asset. This of course makes mathematical sense as it reduces the value of the uncertain future cash flows but not so much logical sense. The second you recognize your inability to ‘predict’ future cash flows should be where the operation stops.

A second assumption I made was the nature of government bonds being ‘risk-free’. Obviously, this is not always the case and depends on the currency/country the business deals in. In the event, that a government bond in the currency of interest is not risk-free, the investor needs to decide on what should be the minimum yield on their investment.

To quickly conclude, an opportunity cost of capital is the best representative of a discount rate. The margin of safety arises as the earnings yield of the business exceeds the opportunity cost of capital and the businesses whose returns are buoyed up by durable advantages require less a difference than their counterparts.