WACC, as anyone who has had a finance course knows, is an acronym for Weighted Average Cost of Capital. Simply put, proponents of WACC believe that you can easily calculate the cost of a company’s capital. In theory, this is important, for all capital does have a cost, even if it isn’t an explicit one. Debt has a clear cost: its after-tax interest rate. Equity has a cost as well (even if some companies seem to think it’s free money that can be issued willy-nilly), but here is where the whole thing enters the realm of silliness. Analysts frequently plug their calculated value for the WACC into their discounted cash flow models and spit out price targets. Sure, the text books say this is ok. It just has no application when it comes to determining intrinsic value in the real world, in my opinion.
There is a very widely taught formula used to determine cost of equity, known as the Capital Asset Pricing Model or CAPM. It says that the cost of equity for a particular company is the sum of the risk free rate and an equity risk premium times beta (Cost of equity = RFR + beta*(risk premium)). Plug in these values and out pops the cost of equity, clear and simple.
It would be if the variables weren’t junk, for as the old saw goes, garbage in, garbage out. Let’s start with risk free rate. I have no problem with using the interest rate on ten year treasuries here. Clearly, equity must cost more than the risk free rate. However, I don’t think fluctuations in the 10 year rate should affect cost of equity calculations. If the 10 year is at 4.5% vs. a long term average of something like 6-7%, should you assume the cost of equity is 1.5% lower, and hence the company is worth more? Therefore, I say if you must calculate WACC, use a long-term average risk free rate.
So we then add the equity risk premium. Again, it makes perfect sense to put in a risk premium. But what is it exactly? In reading through several sell-side analyst reports lately, I have seen the equity risk premium cited as being anything from 2 to 6%. This 4% difference has a HUGE affect on valuation, as we’ll see below.
Now let’s discuss the third input, beta. Beta is used ad nauseum as a measure of risk in the financial world - it is a readily available number and again, the text books say that Beta=risk. Liars! All it tells you is that a stock’s price has varied more or less than the market’s over a particular historical time frame (it’s actually the slope of a regression line between the market’s and a stock’s periodic returns). The market has a beta of 1. If a stock PRICE has been more volatile than the market, it will have a beta >1. If the price has been less volatile, the beta will be <1. As I hope we all know, the fluctuations in a stock’s price frequently have absolutely nothing to do with the underlying company’s fundamentals. The company may be an absolute piece of garbage, but if for some reason its stock price hasn’t fluctuated much, it will have a beta < 1 and hence be deemed less risky than the market and receive a lower cost of capital.
So not only are at least two of three variables in question suspect, but they have a tendency to fluctuate from day to day. For example one day you do this calculation and Yahoo tells you the beta is < 1, the risk free rate is 4.5%, and the pundit du jour says the equity risk premium is 2%, so you get a cost of equity of say 6%. Wow, that’s pretty cheap (quick, tell the company to issue stock!). A month later, interest rates have shot up to 6.5% and Cramer starts bad-mouthing the stock because he thinks its sector has no “pin action” or some such. So the stock has been gyrating since the day-trading geniuses who listen to Cramer have been batting it around. Now the Beta is >1. And oh yeah, the new pundit-du-jour just declared equity risk premiums are 5%, because he thinks he heard Alan Greenspan mutter something about inflation. So now you get a cost of equity of – good lord – 13%!! And yet, nothing has changed with the underlying business.
One big reason to care here is that sell-side analysts spit out hundreds of price targets based on discounted cash flow models that use the WACC as the discount rate, as text books once again instruct. Now, there is absolutely nothing wrong with DCF models if carefully applied while your head is not firmly buried in the sand (or even some place else). This immediately disqualifies most sell side analysts however. Let’s take a quick look-see at the effect the discount rate has on the DCF-derived valuation.
Our example company has 100 million shares out, trades at $30, and produced free cash flow of 100 million dollars last year. We can rationally and conservatively (key qualifications for any assumptions applied to a DCF model) expect the company to grow its FCF by 10% for the next 5 years, 6% for the following 5 years, and then 3% thereafter. Amazingly, both the analyst from Moldy Snacks and the one from Lame and Brothers have both independently arrived at this growth forecast (or maybe the company’s CFO just told them what to use). Seeing as how Moldy took the company public, they would like to support an optimistic price target, so the analyst uses a risk premium of 2%. The risk free rate is 5%, and the stock’s beta is 0.9. Since there is no debt (debt LOWERS the WACC but that’s another discussion – don’t get me started), the analyst gets a WACC of 6.8% (notice the impressive precision). Using this as the discount rate in his DCF, he values the company at $4.051 billion, or 40.51 per share. The stock is only trading at $30, so he sees huge upside and rates it “strong buy”, even though it is trading at 27x next year’s FCF.
The Lame and Bros analyst sees thing differently. He uses a more rational risk premium of 5%, resulting in a WACC of 9.5%. Using the same DCF model, he values the company at $2.309B, or $23.09 per share. It’s trading at $30, so he slaps a HOLD on the stock. Not a sell of course, because hey, they might need some more investment banking business one day.
Now let’s take this all in. The ONLY difference in the two analysts’ DCF models is the discount rate. They were both “carefully calculated with great precision”. So what gives? Garbage in, garbage out. False precision is the curse of idle hands I tell you (or one of the curses anyway). Just because they each chose different equity risk premia, the valuation of the company changes 2-fold. The WACC is a great example of something that appears rigorous yet is completely subjective. Even if both analysts had picked similar risk premia, timing differences may have resulted in them using different Betas or risk free rates, with the same dubious results.
OK, if I’m so darn smart (or even if I’m not), what would do I do? Well, I’ll tell you. In fact I do this just about every day. You see, I could care less what a stock’s beta is or what the Abby Joseph Cohen says the equity risk premium is. I care only about the return my investors get, and the risk (=the risk of permanent capital loss) they have to take to get it. Since the market over time has returned something like 11% annually, I plug a 12% and 15% discount rate into my models, implying that I want a 12-15% return. Simple as that. I then of course haircut this valuation further to achieve a margin of safety. So my model would say the example company is worth $12-16 per share. Hence, I probably wouldn’t pay much more than $10-12 for it.
Do yourself a favor, forget about the WACC and determine what you or your investors require as a return for the risk of investing in equities. That is the true cost of capital.
There is a very widely taught formula used to determine cost of equity, known as the Capital Asset Pricing Model or CAPM. It says that the cost of equity for a particular company is the sum of the risk free rate and an equity risk premium times beta (Cost of equity = RFR + beta*(risk premium)). Plug in these values and out pops the cost of equity, clear and simple.
It would be if the variables weren’t junk, for as the old saw goes, garbage in, garbage out. Let’s start with risk free rate. I have no problem with using the interest rate on ten year treasuries here. Clearly, equity must cost more than the risk free rate. However, I don’t think fluctuations in the 10 year rate should affect cost of equity calculations. If the 10 year is at 4.5% vs. a long term average of something like 6-7%, should you assume the cost of equity is 1.5% lower, and hence the company is worth more? Therefore, I say if you must calculate WACC, use a long-term average risk free rate.
So we then add the equity risk premium. Again, it makes perfect sense to put in a risk premium. But what is it exactly? In reading through several sell-side analyst reports lately, I have seen the equity risk premium cited as being anything from 2 to 6%. This 4% difference has a HUGE affect on valuation, as we’ll see below.
Now let’s discuss the third input, beta. Beta is used ad nauseum as a measure of risk in the financial world - it is a readily available number and again, the text books say that Beta=risk. Liars! All it tells you is that a stock’s price has varied more or less than the market’s over a particular historical time frame (it’s actually the slope of a regression line between the market’s and a stock’s periodic returns). The market has a beta of 1. If a stock PRICE has been more volatile than the market, it will have a beta >1. If the price has been less volatile, the beta will be <1. As I hope we all know, the fluctuations in a stock’s price frequently have absolutely nothing to do with the underlying company’s fundamentals. The company may be an absolute piece of garbage, but if for some reason its stock price hasn’t fluctuated much, it will have a beta < 1 and hence be deemed less risky than the market and receive a lower cost of capital.
So not only are at least two of three variables in question suspect, but they have a tendency to fluctuate from day to day. For example one day you do this calculation and Yahoo tells you the beta is < 1, the risk free rate is 4.5%, and the pundit du jour says the equity risk premium is 2%, so you get a cost of equity of say 6%. Wow, that’s pretty cheap (quick, tell the company to issue stock!). A month later, interest rates have shot up to 6.5% and Cramer starts bad-mouthing the stock because he thinks its sector has no “pin action” or some such. So the stock has been gyrating since the day-trading geniuses who listen to Cramer have been batting it around. Now the Beta is >1. And oh yeah, the new pundit-du-jour just declared equity risk premiums are 5%, because he thinks he heard Alan Greenspan mutter something about inflation. So now you get a cost of equity of – good lord – 13%!! And yet, nothing has changed with the underlying business.
One big reason to care here is that sell-side analysts spit out hundreds of price targets based on discounted cash flow models that use the WACC as the discount rate, as text books once again instruct. Now, there is absolutely nothing wrong with DCF models if carefully applied while your head is not firmly buried in the sand (or even some place else). This immediately disqualifies most sell side analysts however. Let’s take a quick look-see at the effect the discount rate has on the DCF-derived valuation.
Our example company has 100 million shares out, trades at $30, and produced free cash flow of 100 million dollars last year. We can rationally and conservatively (key qualifications for any assumptions applied to a DCF model) expect the company to grow its FCF by 10% for the next 5 years, 6% for the following 5 years, and then 3% thereafter. Amazingly, both the analyst from Moldy Snacks and the one from Lame and Brothers have both independently arrived at this growth forecast (or maybe the company’s CFO just told them what to use). Seeing as how Moldy took the company public, they would like to support an optimistic price target, so the analyst uses a risk premium of 2%. The risk free rate is 5%, and the stock’s beta is 0.9. Since there is no debt (debt LOWERS the WACC but that’s another discussion – don’t get me started), the analyst gets a WACC of 6.8% (notice the impressive precision). Using this as the discount rate in his DCF, he values the company at $4.051 billion, or 40.51 per share. The stock is only trading at $30, so he sees huge upside and rates it “strong buy”, even though it is trading at 27x next year’s FCF.
The Lame and Bros analyst sees thing differently. He uses a more rational risk premium of 5%, resulting in a WACC of 9.5%. Using the same DCF model, he values the company at $2.309B, or $23.09 per share. It’s trading at $30, so he slaps a HOLD on the stock. Not a sell of course, because hey, they might need some more investment banking business one day.
Now let’s take this all in. The ONLY difference in the two analysts’ DCF models is the discount rate. They were both “carefully calculated with great precision”. So what gives? Garbage in, garbage out. False precision is the curse of idle hands I tell you (or one of the curses anyway). Just because they each chose different equity risk premia, the valuation of the company changes 2-fold. The WACC is a great example of something that appears rigorous yet is completely subjective. Even if both analysts had picked similar risk premia, timing differences may have resulted in them using different Betas or risk free rates, with the same dubious results.
OK, if I’m so darn smart (or even if I’m not), what would do I do? Well, I’ll tell you. In fact I do this just about every day. You see, I could care less what a stock’s beta is or what the Abby Joseph Cohen says the equity risk premium is. I care only about the return my investors get, and the risk (=the risk of permanent capital loss) they have to take to get it. Since the market over time has returned something like 11% annually, I plug a 12% and 15% discount rate into my models, implying that I want a 12-15% return. Simple as that. I then of course haircut this valuation further to achieve a margin of safety. So my model would say the example company is worth $12-16 per share. Hence, I probably wouldn’t pay much more than $10-12 for it.
Do yourself a favor, forget about the WACC and determine what you or your investors require as a return for the risk of investing in equities. That is the true cost of capital.
