1998: What is Berkshire's cost of capital?

AUDIENCE MEMBER: I’m Dale Max from University Park, Illinois. And I’ve got a question for each of you. A short question for Charlie, and maybe a little longer for Warren.

My question for Charlie is, in a business school sense, what is the cost of capital for Berkshire Hathaway?

And my question for Warren is that I’ve been on the internet and I look at Yahoo and they give you recommendations for companies. And when I search for Berkshire Hathaway, it shows that nobody is recommending Berkshire Hathaway — (laughter) — despite the fact that there are maybe a thousand people that are wearing signs here, “I love Berkshire Hathaway.” And of course I’ve got mine on, too.

But what seems to be the problem in lack of recommendations?

WARREN BUFFETT: Well, we’re not recommending Yahoo, incidentally, either. (Laughter and applause)

But I’ll let Charlie have that first question about the cost of capital, which has puzzled people for thousands of years. And then —

CHARLIE MUNGER: The way that is taught in most business schools now, I find incoherent. So I’m the one that asks that question and gets the incoherent answers. I don’t have a good answer to a question I consider kind of a stupid question.

WARREN BUFFETT: That isn’t —

CHARLIE MUNGER: What is the cost of capital at Berkshire Hathaway when we keep drowning in this torrent of cash which we have to reinvest?

WARREN BUFFETT: Yeah. There’s really only two questions that get to that, but you don’t need a mathematical answer.

The first question is, is when you have capital, is it better to keep it or return it to shareholders? It’s better to return it to shareholders when you cannot create more than a dollar of value with that capital. That’s test number one.

And if you pass that threshold, that you think you can achieve more than a dollar of value for every dollar retained, then you simply look around for the thing that you feel the surest about, and that promises the greatest return weighted for that certainty.

So our cost of capital is, in effect, is measured by the ability to create more than a dollar of value for every dollar retained. If we’re keeping dollar bills that are worth more in your hands than in our hands, then we’ve exceeded the cost of capital, as far as I’m concerned.

And once we think we can do that, then the question is, is how do we do it to the best of our ability? And frankly, all the stuff I see in business schools — and I’ve not found any way to improve on that formula.

Now the trouble that you may have is that many managements would be reluctant to distribute money to shareholders even if they would rationalize that they would do better than they actually do. But that’s — that may be a danger on it, but that won’t be solved by them hiring a bunch of people to come up with some cost of capital that also justifies them keeping the money, because that’s what they’ll do otherwise.