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Collection: Warren Buffett - #287 'Opportunity Cost'


Video Link: https://youtu.be/TTkLTwlyREg


In this episode, Warren Buffett and Charlie Munger were asked in terms of a discount rate, do they feel it’s appropriate to use Berkshire's cost of capital at the current risk-free rate?


In this episode, you’ll learn:

  • Why you shouldn't look at cost of capital?

  • What does it mean that “intelligent people make their decisions based on opportunity cost?”

To check out all Collection: Warren Buffett <click here>

 

[Transcript]

(Source: https://buffett.cnbc.com/2003-berkshire-hathaway-annual-meeting/)

~ Please visit the site above for full video of Berkshire Hathaway Annual Meeting.

AUDIENCE MEMBER 00:00

Second question would be, in terms of a discount rate, do you feel it’s appropriate to use your cost of capital at the current risk-free rate?


WARREN BUFFETT 00:09

The question about a discount rate, when you talk about our cost of capital, that’s worth bringing up, because Charlie and I don’t have the faintest idea what our cost of capital is at Berkshire, and we think the whole concept is a little crazy, frankly.


But it’s something that’s taught in the business schools, and you have to be able to answer the questions or you don’t get out of business school.


But we have a very simple arrangement in terms of what we do with money. And, you know, we look for the most intelligent thing we can find to do.


If we’ve got money around or — if we look — we don’t buy and sell businesses this way, but in terms of securities we would — if we find something that’s at 50 percent of value, and we own something else at 90 percent of value, we might very well move from one to another. We will do the most intelligent thing we can with the capital we have.


And so, we measure alternatives against each other, and we measure alternatives against dividends, and we measure alternatives against repurchase of shares.


But I have never seen a cost of capital calculation that made sense to me.


How about you, Charlie?


CHARLIE MUNGER 01:17

Never.


And this is a very interesting thing that’s happened. If you take the most powerful freshman text in economics, which is by [Greg] Mankiw of Harvard, and he says on practically the first page that “intelligent people make their decisions based on opportunity cost.”


In other words, it’s your alternatives that are competing for the use of your time or money, that matter in judging whether you take action or not.


And of course, those vary greatly from time to time and from company to company. And we tend to make all of our financial decisions based on our opportunity costs, just as like they teach in freshman economics.


WARREN BUFFETT 02:09

Yeah.


CHARLIE MUNGER 02:10

And the rest of the world has gone off on some crazy kick where they can create a standard formula, and that’s cost. They even get a cost of equity capital for some business that’s old and filthy rich. It’s a perfectly amazing mental malfunction.


WARREN BUFFETT 02:31

Yeah, it’s a — (Laughter)


Number 3. Is there anybody we’ve forgotten to offend? (Laughter)

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