Opportunity Cost’s Application — Step by Step Calculation
Subject : Opportunity Cost’s Application — Step by Step Calculation
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The Real Definition and Formula :
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Opportunity Cost (Unit: $ Per Dollar Opportunity)
= Cost of Opportunity
= The Cost Spent to Own A Dollar Worth of Opportunity
= P/E Weight Ratio
= P/E ÷ Companion Variable
= P/E ÷ ( Gnet_income÷CTAC_Ratio×ROA÷CTAC_Ratio )^(1÷4)
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ROA
= 100 × Net Income ÷ Total Assets
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CTAC Factor
= 30Y Government Bond Yield Factor × (1 + Total Liabilities/Total Equity × (1 + 2 × 30Y Government Bond Yield Ratio)) ÷ (1 + Total Liabilities/Total Equity)
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CTAC
= 100 × ( CTAC Factor - 1 )
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The lower Opportunity Cost would be the better choice.
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The Opportunity Cost is the other name of P/E Weight Ratio which was expounded by the concept in the Mental Model of Benjamin Graham:
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‘In the short run, the market is a voting machine but in the long run, it is a weighing machine.’
— Benjamin Graham
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:: Case Study ::
There are two companies, both are good compounders.
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Company A:
Stock Price = 100, EPS = 9, ROA = 15%, CTAC= 10%, Net Income Growth = 18%
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Company B:
Stock Price = 80, EPS = 9, ROA = 7.5%, CTAC = 8%, Net Income Growth 20%
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Which is of better choice?
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We have no clue if just by looking at the individual metrics and ratios.
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We have to blend the metrics and ratios and find out their intrinsic synergy strength.
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:: Opportunity Cost’s Better Choice Application — Step by Step Calculation ::
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Step 1:
What are their Opportunity Cost respectively?
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COMPANY A:
Opportunity Cost
= Cost of Opportunity
= The Cost That You Have Paid For Buying a Dollar Worth Opportunity
= P/E Weight Ratio
= P/E ÷ ( Gnet_income÷CTAC_Ratio×ROA÷CTAC_Ratio )^(1÷4)
= (100/9) ÷ (18÷0.10×15÷0.10)^(1÷4)
= $ 0.8667953035 Per Dollar Opportunity
= Bought a dollar worth opportunity for $ Opportunity Cost
= Bought a dollar worth opportunity for $ 0.8667953035
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COMPANY B:
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Opportunity Cost
= Cost of Opportunity
= The Cost That You Have Paid For Buying a Dollar Worth Opportunity
= P/E Weight Ratio
= P/E ÷ ( Gnet_income÷CTAC_Ratio×ROA÷CTAC_Ratio )^(1÷4)
= (80/9) ÷ (20÷0.08×7.5÷0.08)^(1÷4)
= $ 0.7184055128 Per Dollar Opportunity
= Bought a dollar worth opportunity for $ Opportunity Cost
= Bought a dollar worth opportunity for $ 0.7184055128
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Step 2 :
Compare their Opportunity Cost.
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Since :
Company A’s Opportunity Cost 0.8667953035 > Company B’s Opportunity Cost $ 0.7184055128
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Therefore :
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Company B is of better choice than Company A in the search for a Better Compounder.
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Moral of this article :
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Mental Model : Read→ Think →Quantify
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If Quantification step is skipped, the Mental Model is just a piece of music : Good For Listening But Not For Investing.
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SIDENOTES :
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Opportunity Cost is a useful tool.
Opportunity Cost formula used by superinvestor:
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Peter Lynch : PEG
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Warren Buffett, Charlie Munger, Li Lu, Joel Greenblatt : PEROIC
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Bruce Greenwald : PE(1/Cost of Capital)
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P/E is useless if valued alone.
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BUT The characteristic of P/E is metamorphosed when being fused with a Campanion Variable described by Professor Aswath Damodaran.
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You can’t equate a ferum to a steel (ferum + carbon); an oxygen to water (H2O).
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The Companion Variable of P/E are :
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Growth — PEG Model by Peter Lynch
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Growth + DY — PEGY Model by Peter Lynch
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ROIC — PEROIC Model by Warren Buffett, Charlie Munger, Li Lu, Joel Greenblatt
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(1/Cost of Capital) — EPV Model by Bruce Greenwald
DCF÷EPS — DCF Model
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Summary :
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Opportunity Cost
= P/E ÷ Companion Variable
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Opportunity Cost is an Opportunity Density Weighing Machine At The Time of Measurement, it spells The Cost Spent to Own A Dollar Worth of Opportunity.