The Cost of Capital and The Price of Time
The Cost of Capital and the Price of Time
We’ve all heard the phrase “time is money”.
But what exactly is the “price of time”? How do we calculate or quantify how much time is worth? When we invest, what assumptions are we making? Just because there have been gains in the past, why should we expect the future to “rhyme”?
And most importantly, why do we “invest the way we invest”?
If you would like to do a deeper dive into time, money, and interest, I highly recommend Edward Chancelor’s The Price of Time: The Real Story of Interest for an entertaining stroll through history and the evolution of financial markets, loans, and interest.
For today, I want to look at the idea of “cost of capital” for companies. It’s probably easier to think about it from the debt or loan perspective, so let’s start there.
Imagine two business owners standing in line at the local bank asking for a loan. One of them is a guy by the name of Phil and he leads a global company that makes shoes and has a brand related to Greek mythology.
The other is a guy named Bob, and his company is in the whole grain food market. A successful company that employs hundreds of people, but nowhere near the size of Phil’s company.
Both gentlemen ask the banker for a $10 million loan.
Question: Who pays the higher interest rate? Phil or Bob?
Wouldn’t the bank like to charge Phil the same or more than Bob? After all, his company can afford it, right? What Phil knows is that he has more ACCESS to capital. If the terms of the loan aren’t to his liking, he will be able to go down the street (or across the globe!). Bob on the other hand, has fewer options.
The result: It is highly likely that the terms of Phil’s loan will be better than those for Bob’s loan. Both will be able to “rent” money at the price of an interest rate and pay it back over time. This is their “Price of Time”. And it is their “cost of capital”.
Clearly this is just an analogy. But it carries over to the equity side as well. If two companies both look like their future earnings will be comparable (on a relative basis), few would choose to buy stock of the small company. After all, the big company has more resources and can likely weather more financial storms. The way small companies can attract more investors is to at least *appear* to have higher returns than big companies. Some of the small companies may become bankrupt. Some may be the next Nike. On average, the asset class of small company stocks is likely to outperform large company stocks over long periods of time. So again, the cost of capital for small companies is expected to be higher than those of big companies.
Our mantra, which you probably can recite in your sleep: Systematic, Unemotional and Diversified! That diversification is critical to our financial success. It’s critical to avoiding unpleasant surprises. Does it prevent losses? No. But it does mean we are more likely to achieve the underlying asset class returns and to be rewarded for taking the risks we take.
P.S. – The above analogy is one I’ve been telling for years. Bob Moore, founder of Bob’s Red Mill, recently passed away. He is reported to have said if he had to do his life over, he would have started his business sooner (he didn’t found the business until mid-life). Through his business he changed the world (at least locally). How much more could he have accomplished if he started earlier? How much less could he have accomplished if he waited another 5 or 10 years?
If time is money, it also can be said that money is time. In our planning process the scarcest resource we have is time. As it is written, “teach us to number our days”. How are we spending our time? I’m happy to spend money to buy time. Time with my family and loved ones; time to serve clients; time to change the world around us in small and maybe imperceptible ways. How about you? How are you spending your time? What did that capital cost you?
Sincerely,
Craig Smith, CKA®, CFP®, CFA®
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
