Why Buffett Ignores Wall Street’s Favorite Formula
- Wall Street uses complex formulas (WACC, beta) to adjust for “risk”
- Buffett thinks this is “mathematical gibberish”
- His approach: use a simple comparison rate, then only buy with a big safety buffer
- The lesson: don’t try to measure risk precisely — just avoid situations you don’t understand
The MBA Approach
In business school, they teach you to value companies using something called WACC — “Weighted Average Cost of Capital.”
It’s a formula that tries to figure out the “right” rate to convert future money into today’s money. The formula involves:
- How risky the stock is compared to the overall market (something called “beta”)
- The interest rate on debt
- A “market risk premium”
If a company seems risky, you use a higher rate. This makes future profits worth less today, so the company looks less valuable.
Sounds logical, right?
Buffett disagrees. Strongly.
“Mathematical Gibberish”
Here’s what Buffett said:
“If you say I’m going to stick an extra 6 percent in on the interest rate to allow for risk — I tend to think that’s kind of nonsense. I mean, it may look mathematical. But it’s mathematical gibberish in my view.”
And his partner Munger:
“I’ve never heard an intelligent cost of capital discussion.”
What’s their problem with it?
The False Precision Problem
The WACC formula requires you to estimate several numbers:
- How “risky” the stock is (beta)
- What return investors expect from the whole market
- What interest rate the company pays on debt
Each of these is a guess. And small changes in your guesses create huge swings in your final answer.
- Use 10% cost of capital? The company is worth $100.
- Use 11% instead? Now it’s worth $90.
- Use 9%? Now it’s worth $112.
Can you really tell the difference between 9%, 10%, and 11%? Probably not. But your “precise” valuation swings by 20% depending on which you choose.
Buffett’s view: this precision is fake. You’re just making up numbers and pretending they’re scientific.
The Beta Problem
“Beta” measures how much a stock bounces around compared to the overall market. Wall Street says higher beta = higher risk = you need higher returns.
But think about what this means in practice:
A stock drops 50% because of a market panic. Nothing has changed about the business — customers are still buying, profits are still flowing. But because the stock bounced around a lot, beta goes UP.
According to Wall Street math, this stock is now RISKIER and you should demand a higher return. It’s now LESS attractive to buy.
But wait — wouldn’t a 50% price drop for the same business make it MORE attractive?
Buffett thinks so:
“The Washington Post example: In 1973, the stock dropped 50% despite the business being fine. Beta said it was now riskier. Buffett said it was cheaper, bought heavily, and made a fortune.”
Beta measures price volatility. Buffett doesn’t think price volatility is risk. Real risk is permanent loss of your money — not temporary price swings.
Buffett’s Simpler Approach
So if Buffett doesn’t use WACC, what does he use?
He uses the government bond rate as his yardstick.
From a 1997 shareholder meeting:
“We use the risk-free rate merely to equate one item to another… Obviously, we can always buy government bonds. Therefore, that becomes the yardstick rate.”
The logic: - You can always put your money in government bonds and earn, say, 4% safely - Any other investment should be compared against that - If a stock doesn’t clearly beat the safe option, why bother?
This gives him a clean comparison without fake precision.
How He Handles Risk
If Buffett doesn’t adjust his rate for risk, how does he handle risky situations?
Two ways:
1. He Only Invests in Things He Understands
“We try to deal with things about which we are quite certain.”
If you truly understand a business — its customers, competition, and future — there’s less uncertainty. The “risk” is lower because you actually know what’s going on.
And if you don’t understand it? Don’t invest. No rate adjustment will save you from being wrong about the fundamentals.
2. He Demands a Big Safety Margin
Instead of adjusting the rate, Buffett demands a big gap between price and value.
If he calculates a business is worth $100: - He won’t buy at $95 (only 5% margin) - He might buy at $70 (30% margin) - He’d love to buy at $50 (50% margin)
This margin of safety protects against: - His estimates being wrong - Unexpected problems - Things he didn’t think of
It’s a much simpler approach than trying to precisely measure “risk.”
The 10% Hurdle
Buffett also has a minimum return requirement:
“10% is the figure we quit on — we don’t want to buy equities when the real return we expect is less than 10%, whether interest rates are 6% or 1%.”
This isn’t a discount rate for calculations. It’s an opportunity cost filter.
Buffett knows he can usually find 10%+ returns somewhere. So why accept less? Even if something looks “cheap” at 7% expected return, he’ll pass and wait for something better.
The Bottom Line
Wall Street’s approach: 1. Calculate complex rates adjusted for “risk” 2. Plug into formulas 3. Get precise-looking (but fake) answers
Buffett’s approach: 1. Use a simple comparison rate (government bonds) 2. Only invest in things you truly understand 3. Demand a big safety margin 4. Walk away if the return doesn’t obviously beat alternatives
The lesson: don’t try to measure risk with precision. Just avoid situations you don’t understand and insist on a large margin of error.
Wall Street uses complex formulas (WACC, beta) to adjust valuations for “risk.” Buffett thinks this creates false precision — the numbers look scientific but they’re really just guesses.
His alternative: use a simple baseline rate (government bonds), only invest in things you understand, and demand a big safety margin.
Next up: Part 4 — Circle of Competence. How do you know if you really understand a business? And why does it matter so much?
References
Buffett, W. (1997). Berkshire Hathaway Annual Meeting. 25iq.
Buffett, W. (2003). Berkshire Hathaway Annual Meeting. Yahoo Finance.