Buffett & Munger on Cost of Capital: Don’t listen to what they say but look at what they do

After bashing David Einhorn for his Consol Energy WACC assumption last week, by chance I read at the very good 25iq blog an article on how Buffett and Munger publicly speak about those things.

Indirectly, this is clearly a slap in my face because even the headline already says it all:


Why and how do Munger and Buffett “discount the future cash flows” at the 30-year U.S. Treasury Rate?

The post summarizes what Charlie and Warren have said over the years with regard to cost of capital and discounting. I try to summarize it as follows:

  • They seem to use the same discount rate for every investment, the 30 year Treasury rate
  • in a second step they then require a “margin of safety” against the price at offer
  • they estimate cash flows conservatively
  • Somehow Buffet seems to have a 10% hurdle nevertheless
  • Buffett compares potential new investment for instance with adding more to Wells Fargo

So if Buffett doesn’t use more elaborated methods why should any one else ? Was I wrong to beat up David Einhorn because he used a pretty low rate for Consol Energy ? Add to this Mungers famous quote “I’ve never heard an intelligent cost of capital discussion” and we seem to waste a lot of time here, right ?

Well, as a starter, this is one important sentence from Buffett quoted in the post:

We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate


So yes, if you don’t invest in anything more risky than Coca Cola, then a standard low discount rate makes sense. I will most likely not pay off to spend a lot of time analyzing if Coke’s beta is 0,95 or 0,97.

However if your investment universe is wider, then using just one discount rate can really be dangerous. A classic example for this are for instance the Global P/E comparison charts which always tell you that Russia looks cheap at a P/E of 6. Unfortunately, with a 15% local risk free rate, using a standard 10% hurdle would make even a Russian Government bond look good at least on paper. So how can we solve the issue if one wants to invest across a wider risk spectrum than just blue chip stocks ?

I guess Buffett and Munger sometimes over-simplify what they are doing, especially when they are answering one question after the other in their annual meeting. One hint that Buffet thinks more differentiated about his “true” cost of capital can be found for instance in Berkshire’s 2007 annual report where he comments on his 1993 acquisition of Dexter Shoe:

Finally, I made an even worse mistake when I said “yes” to Dexter, a shoe business I bought in 1993 for $433 million in Berkshire stock (25,203 shares of A). What I had assessed as durable competitive advantage vanished within a few years. But that’s just the beginning: By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6% of a wonderful business – one now valued at $220 billion – to buy a worthless business.

So he clearly is aware that the cost of issuing new Berkshire shares is really high. Buffett again used own stock to acquire Burlington Northern with some new Berkshire Stock in 2009:

Buffett, who has long preferred all-cash deals, is paying $100 per share in cash and stock for the 77.4 percent of BNSF shares that Berkshire does not already own.

I am pretty sure that Buffett didn’t discount Burlington’s cash flows with the 30 year treasury rate but thought very hard on how much shares he wants to put into the deal following the Dexter Shoe experience 25 years ago. I think 2009 was also one of the years where Buffett was to a certain extent capital constrained. He saw so much good deals that their return seemed to have outweighed the high cost of his own stockthat he actually did the Burlington deal and offering own stocks.

If I would have a chance to ask Buffett a question I would ask him how he determined how much Berkshire stocks to use in the offer. He must have done some “cost of capital” calculaton back then.

Another hint that Buffett’s investment apporach is much more sophisticated can be easily found a year earlier, when in the height of the financial crisis, he took a stake in Goldman Sachs:

Fabled investor Warren Buffett took advantage of the turmoil in the markets last week to make a shrewd $5 billion investment in the beleaguered but best-run major Wall Street securities firm, Goldman Sachs.

Mr. Buffett’s Berkshire Hathaway, which owns companies in a variety of industries from insurance to candy making, is purchasing $5 billion of preferred stock with a juicy 10% dividend yield. Berkshire also is getting warrants to buy $5 billion of Goldman common stock at $115 a share, $10 below Goldman’s share price when the deal was announced last Tuesday.

This was clearly a more risky deal than normal for Buffett and clearly he demanded more than 10%. The 10% on the Coupon were only the starter, the “juicy part” was getting multi-year,in-the-money warrants for free. Without calculating the values, the warrants will easily have added 5-10% p.a.on top of the preferred coupon, so all in all Buffett required Goldman to pay somewhere between 15-20% p.a. for this deal.

I am pretty sure that Buffett didn’t project cash flows for GS and never tried to estimate the appropriate WACC or so. Nevertheless he seems to have a pretty good idea what he needs to earn on more risky transactions. This is how he explained the transactions in his 2008 annual report:

On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus. To fund these large purchases, I had to sell portions of some holdings that I would have preferred to keep (primarily Johnson & Johnson, Procter & Gamble and ConocoPhillips).

It is also obvious that in times where opportunities are plenty, he is selling existing holding which he deems less attractive than the new investments. Again, his “buy and hold forever” mantra clearly sometime gets overruled by opportunity.

Interestingly, on the same page we find this paragraph which I have actually not noticed before:

I made some other already-recognizable errors as well. They were smaller, but unfortunately not that small. During 2008, I spent $244 million for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”

This is another example of Buffett sometimes doing exactly the opposite of what he is saying. For him this 244 mn were a mini gambling position and he lost. In public he will aways argue for concentrating positions and play it safe. He can obviously do whatever he wants but it is also an example not to put everything he or Charlie says as a carved in stone commandment for any value investor.

What you can learn from Buffett with regard to Cost of Capital

Despite Warren being a genius and owning his own multi billion company, I think there is still a lot to learn from him. In my opinion, those are the most important lessons for investors:

1. Do have a rough idea what you need to earn for a given risk profile. For more risky deals, require a higher return
2. Use common sense to determine required returns. For instance the return for a stock has to be higher than the yield of a bond of the same company
3. Try to compare every new potential investment with your old ones. If the old ones look better, then add to the existing ones
4. If the new investment is better than the old ones, it is OK to sell some of the old ones if you don’t have enough cash for the new opportunity
5. Make sure to compare apples with apples, it’s easier if you do only investments with similar amount of risk.
6. Make sure your overall risk profile of stocks matches your own risk appetite as well as those of your investors
7. Keep it simple






  • I have to disagree with your premise. It seems you are saying Buffett solely relies on a DCF model to value and pick his stocks. This is misleading. You can read thousands of pages of his annual letters, interviews, random quotes, he has never said he has one method of valuing a business.

    When valuing he looks everything. FCF multiple, DCF, Net income multiple (PE), NAV, etc…and he is cross referencing these numbers as a check.

    Actually i am not even to sure what your argument is and am not completely sure what I am arguing against. Maybe it is because i am slow.

    • No,I don’t say that. The only thing I say is that he doesn’t use any singular approach. The post on 25iq argued he uses always the 30 year Treasury rate and/or a 10% hurdle.

  • This is an exceptional blog but I feel this post misses the fundamental point.

    To loosely paraphrase Munger, CAPM is nonsense and beta has no place in forecasting an investment outcome. This is the key distinguishing factor in their approach.

    Buffett’s approach is grounded in two key concepts, firstly, the present value of $1 of future earnings is simply $1 discounted by the time value of money, and secondly, beta does not measure risk of capital loss. To put it cynically, the much maligned (by Buffett and Munger) financial theory basically tells you that the present value of $1 of future earnings is equal to the future cash flow discounted by how lumpy its historical market price is.

    Ignoring the omission of beta, Buffet’s approach just frames the question differently by simply separating the hard data from the soft data, so you know when you are dealing with estimated real returns, and when you are dealing with a qualitative assessment of risk.

    1) You treat all investments as equal, discounting their future cash flows by the 30 year treasury rate (hard data).
    2) Then you introduce a qualitative assessment. Even in spite of not using beta, you could still set an arbitrary required return (i.e. 10%). This doesn’t work for Buffett however, because it doesn’t adjust for risk of capital loss, you might accept a 10% return on Coca Cola, but it isn’t going to suffice for a thermal coal producer (soft data judgments call).

    By approaching it this way he is estimating a real rate of return, and then doing the risk-adjusting step with his gut-feel and intuition. Whereas most people would blend these two steps into one and create a risk-adjusted output based on a beta value which Buffett contends is meaningless, or a set required rate of return, which does not adequately provide for different levels of risk.

    • I don’t get your point. My point was that the approach you are describing works if you stay within the “Low risk” universe. As we know, even Buffett doesn’t stay always in the “Buffett universe” and clearly is requiring morethan 10% as evident in cases like GS where he negotiated directly.

      • I think you are misinterpreting Buffett’s quoted 10% figure. This isn’t a hurdle rate, he is just citing 10% as a minimum requirement to even consider entering the equity space. You can disregard this figure, the only 10% investment Buffett would ever willingly make would be a risk free treasury bond.

        The basis of the approach is that there is no set hurdle rate. You are estimating the real return provided by a future set of cash flows without any noise such as Beta. It works in any risk universe because the required return is a moving target.

        For example, you might identify an investment in a durable mature business which you expect to yield a 12% real rate of return, and an investment in a cyclical commoditized business that you expect to yield 15% real rate of return. You invest in the first business, because your understanding of each respective business tells you that the first investment is a far more attractive risk-reward proposition given the durability of each business.

        All valuation boils down to an estimate of future cash flows, adjusted for risk/probability/durability in some way. Buffett’s method just frames it in a different way. The real objection/omission from the approach is to the use of CAPM or a fixed hurdle rate. There is also something to be said about using a 30 year rate, which helps smooth out some of the shorter term under/overvaluation that results from changes in short term rates. For example, anyone using a 5-year or 10-year rate in a WACC calculation today is setting the bar 1% – 1.5% lower than Buffett is with a 30 year rate.

      • memyselfandi007: you were right (or along the path to rightness). this other commenter just seems to have a lot of words they needed to get out of their system.

  • This is an exceptional blog but I feel this post really misses the fundamental point.

    To very loosely paraphrase Munger, CAPM is nonsensical and beta has no place in forecasting an investment outcome. This is the key distinguishing factor in their approach.

    Buffett’s approach is grounded in two key concepts, firstly, the present value of $1 of future earnings is simply $1 discounted by the time value of money, and secondly, beta does not measure risk of capital loss. To put it cynically, the much maligned (by Buffett and Munger) financial theory basically tells you that the present value of $1 of future earnings is equal to the future cash flow discounted by how lumpy its market price is along the way.

    Other than that, Buffet’s approach just frames the question differently. Ignoring the omission of beta, Buffett’s approach simply separates the hard data from the soft data, so you know when you are dealing with estimated real returns, and when you are dealing with a qualitative assessment of risk.

    1) You treat all investments as equal, discounting their future cash flows by the 30 year treasury rate (hard data).
    2) Then you introduce a qualitative assessment. Even in spite of not using beta, you could still set an arbitrary required return (i.e. 10%). This doesn’t work for Buffett however, because it doesn’t account for risk of capital loss, you might accept a 10% return on Coca Cola, but it isn’t going to suffice for a thermal coal producer (soft data judgment call).

  • Hi, and thanks for a good post. I would like a “share on twitter” button on your blog!

    And also, I was wondering if you ever looked at Ubiquiti Networks? I know you’re good with “odd” business models (I’m thinking about Admiral and TGS Nopec among others), and it would be very interesting to hear your point of view on Ubiquiti. A few links on Ubiquiti in case you are interested:



    The links might be a bit outdated on the numbers side. The company is mainly a producer of network products, very innovative and with a CEO that owns 60 % of the company and takes a 1 $ yearly salary. He started the company with credit card debt and it is run very, very capital-tight. They never took in much venture- or public capital. The business model is entirely unique and the growth has been substantial, but the company also has had some bad publicity and the business model makes the growth a bit lumpy and the visibility regarding revenue streams is not very clear. Bill Gurley, a seasoned venture capital partner, has said this about UBNT:
    “What Robert has built with Ubiquiti Networks is the most radically disruptive business model I have ever seen. This represents the future of networking and stands to fundamentally upset the industry status quo.”

  • As far as I understood Buffet and I also read it in your article, you still may boil down his investments to a quite simple looking recipe.
    In times of “elefant huntings”, where Buffet has lots of cash but is short of opportunities, investments have to pass two hurdles:
    1. A profitability of 10% per year. Roughly calculated as EBIT/EV, if I understood it correct in earlier articles. (I think to have read that this hurdle was 15% in days of yore, but with growing business Buffet had to reduce it).
    2. A business modell that he understand to have a long and profitable durability.
    Both hurdles have to be met, otherwise he prefer holding cash. If the second hurdle is not met he will not accept a higher profitability (first hurdle) as compensation, as he don’t see it as a safety net.

    In times of plenty opportunities Buffet increases the first hurdle. He simply can choose between several good projects. We have seen this several times, e.g. at the financial crisis around 2008.
    Of course even Buffett is not safe of making mistakes (or loosing his bets), as he admitted regarding Tesco, Dexter and the Irish banks. But I still think while buying them he was assured they have (or find again) a long living business modell, so it met the second hurdle.

    Probably he had insights as well as blind spots that made him believing they are safe bets. And perhaps he still mainly invests in the States because he had to pay dear to learn with failings like Tesco and the Irish banks, that investments abroad are much harder to evaluate for him.

    • So while agreeing with most of your conclusion list, I dont think they fit with Buffets investment style:
      “1. For more risky deals, require a higher return” – Yes, its a rule I follow too. But I dont see evidence that Buffet do as well.
      “2. For instance the return for a stock has to be higher than the yield of a bond of the same company” – As far as I understad that is already to difficult for the Buffet formula. Profitability greater 10% (and no better alternatives) – Bingo!
      “4. If the new investment is better than the old ones, it is OK to sell some of the old ones” – Difficult! That only worrks for his share holdings. If he buy an entire corporation (and took it down from stock exchange) he will not sell it again. IMHO that’s a fundamental issue of his investment philosophy as it offers him better prices (Better sell cheaper to Buffet than more expensive to privat equity as Buffet offers better long term perspectives).
      “7. Keep it simple” – I think it is more like “Learn to describe it simple.” It is not simple at all to understand the chances and risks of such a diversity of companies and business modells as Buffet bought in his life. Being able to do that with such a big success rate requires a genius. It is said that Buffet is among very few investors that buy companies of almost all industrial sectors (blind spots at IT included), so people trying to sell big companies can always contact him.

      • Hi Roger, for 1. I agree with you to a large extent. But not everything what buffett does should be replicated by ordinary investors, especially if more risky investments are in scope.
        For 2. I think Buffett would say: don’ t even think about it unless you get a special deal with pre f’s plus warrants

  • Thanks. This one I like a lot

  • I’m an amateur investor looking after families money. I really enjoy these articles. They help to educate me about investing.

    I endeavour to take in what I’ve learned from Graham, Buffett, Greenblatt and so many folks like yourself I read online. I find the precise accounting that comes with things like discounted cash flow don’t work for me. I don’t like formulas that kick out hugely different results based on assumptions.

    I don’t think I could properly describe my strategy – I bought CNX because I think it will survive the downturn and do well coming out the other end. I liked Einhorn’s basic argument. I bought very little (1% position) because I don’t like companies with lots of debt. Did the same thing with a Mortgage insurer (MTG)…bought it at 2.50 watched it tank to .50 and sold it around 6 eventually (missed a lot of upside). Maybe this time not so lucky – we will see.

    I tend to get a little star struck – and can be a little optimistic at times, so I really valued a counter to Einhorn’s presentation.


    Jim Maron

  • In my opinion it`s the same, at least based on the outcome. If you discount something with the risk-free rate and then apply a big margin of safety, which reflects the individual risk-profile you see in the company, you basically get the same result, as if you discount it with a higher discount rate, which reflects the same risk-profile, in the first place. The difference lies just in the method you use. And I am pretty sure Buffett has never talked about how big a margin of safety he uses in every single investment he makes. So if you will he factors his “cost of capital” (if you can even call it that way) in at a different stage of the process, but as I have said it doesn`t make a difference in the end.

    The only thing Buffett and Munger certainly don`t do is to calculate their cost of capital in a way which is proposed by modern finance theory.

    And I definitely agree with you that they do oversimplify wherever they can.

    • To be honest, I don’t like the “margin of safety” concept at all.

      A very risky investment like Consol will mabye have a big margin of safety if discounted at 3%, lets say 2 times, a conservative one like Fastenal a lot less. Nevertheless, Fastenal could be the better investment as the implied risk of Consol maybe eats up the whole “margin of safety”.

      I think especially if you want to decide between a very risky and a low risk investment, margin of safety is not helpful. This is why a lot of beginning value investors end up with stuff that blows up on a regular basis (Globo etc…..).

      They see the low P/Es, assume a high margin of safety but are not aware of the risk.

      • That certainly depends on how you define the term “margin of safety”. If you look at it as a cushion which could be “eaten up” by the possibility that you have the individual risk of the company wrong then it has the same function as an individually compiled discount rate. If you see high individual business risk then you use a bigger margin of safety or you don`t invest at all.

        And of course someone who knows a lot about a certain business can use a lower margin of safety (or a lower discount rate if he prefers that concept). The difficulty here lies not in the method you use in valuating the company but in correctly judging your own level of certainty.

        • Agreed. For me personally it is a lot easier to work with discount rates. That makes comparisons easier across the risk spectrum.

        • How do you account for opportunity cost, if at all, in your discount? I see a lot of people using much lower discount rates due to ZIRP which doesn’t actually reflect the risk of the investment. Implying all risk within the discount rate and seeing if you meet personal hurdle rate, which is obviously higher than opp cost, seems simplest to me.

        • I don’t have personal opportunity costs. For me it is importatnt that I get more return than what should be expected based on the risk profile. This could be a 5% return for a risk free investment or a 20% return for an investment which would be fairly valued at 15%.

          So the discount rate in my opinion should only reflect the risk of the investment, nothing else. If and how to apply a personal hurdle is a different question. As I mentioned above, I have no hurdle.

        • Do you think that there is something like objective business risk which determines the “fair” risk premium for a certain company? I am not sure about that, since it would basically mean, that for example a man like Buffett would have to apply the same risk premium in evaluating a company, as I would have to. Even if he certainly knows a thousand times more about the insurance business, than I do…

  • -Keep it simple: your seven points could be simplified into one point: 1. “It is always a function of opportunity cost”

    – Munger said that Buffett used to require an unlevered pre-tax yield of 13%. It is clear from recent deals that they lowered the hurdle significantly in order to get deals done. PCP and Heinz, for instance.

  • To be perfectly honest, I don`t get it. Where is the difference between using a lower discount rate and then applying a bigger margin of safety on the one hand and using a higher discount rate which reflects the true risk of the investment on the other hand?

    I can`t see Buffett doing something different than what he was saying it.

    • Well, firstly he is clearly doing riskier investments despite saying that they only do safe deals. Secondly he is thinking about his own cost of capital but maybe doesn’t discuss it with Munger. And thirdly, applying low disount rates to high risk investments will lead to optically high margins of safety which are not really there. I am pretty sure he didn’t value the Irish Banks with the 30 year treasury rate.

      • Seems like the way you vies risk is different from Buffett. When Buffett says something is low risk, it not that the investments themselves are low risk, but the overall risk based on the the price of the investment. A low enough price can make a high risk investment safe. You also seem to use the term margin of safety differently. There is no optically high margin of safety. Both Munger and Buffett refer to MOS as an engineering principle, so if something doesn’t satisfy a required MOS level, it cannot be purchased.

        There is much of a difference in adjusting the discount rate vs adjusting the MOS for risk, as long as you do one and not the other. The important thing is to understand how to adjust each to account for the type of risks in an investment. Then one thing to avoid is to adjust discount rate based on risk, and then adjust MOS based on risk again. This can lead to confusion, double counting, or cancellation effect, depending on mental bias at the time.

        • hmm, i think you get that one wrong. Buffett, at least most of the time, only does investments where the investment is low risk, mainly because it is “fortified” by a moat. I cannot remember that he recommended to buy really risky investments if they are cheap enough.

        • You are thinking about his equity investments, but he also deals in derivatives. From 2008 share holders’ newsletter,

          “Considering the ruin I’ve pictured, you may wonder why Berkshire is a party to 251 derivatives
          contracts (other than those used for operational purposes at MidAmerican and the few left over at Gen Re). The
          answer is simple: I believe each contract we own was mispriced at inception, sometimes dramatically so. ”

          This illustrate the way he really thinks. Mispricing can lower the risk enough for a risky vechicle to become safe. He also discusses regularly that if he wasn’t managing such are large amount of money, he would invest in very different assets and get much better returns. However, due to the size of Berkshire’s portfolio, the things are he can buy are generally limited to fairly well established, large companies, which tends to be lower risk.

        • Somehow we have turned full circle in this discussion.If you read my initial post, you will see that I was actually making the point that Buffett sometimes does risky things and that he most likely doesn’t use the 30 year treasury rate or a 10% hurdle to calculate whatever he calculates.

          And to make clear: I am not a Buffett expert who claims to know exactly what Buffett does and how he thinks. I just thought that 25iq post was a little bit too simplistic.

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