Previously, we looked at the building blocks of a discounted cash flow model - why you may want to use one, what assumptions go into developing one and what the basic formula you would use looks like. We also discussed the concept of the time value of money and discount rates, as well as the cost of capital. I want to now introduce weighted average cost of capital, a measure that businesses use when assessing the financial viability of internal projects.
What is WACC?
For a company, cost of capital is the amount of money that it needs to service its creditors, equity holders and anyone else who has a claim on its cash flow. It represents the minimum return the business needs to earn on its existing assets to satisfy these stakeholders. When trying to decide whether to allocate capital to a new project, company management needs to ascertain whether its future cash flow will be enough to pay back the investors who supplied that capital.
Stable, mature companies in predictable industries typically have a lower cost of capital than newer companies in more risky industries whose earnings may be a lot more volatile. Generally speaking, investors in utilities, consumer staples and telecoms know exactly what they are getting into, and are happy to receive a smaller return on their invested capital in exchange for the near-certainty they will get that return and that their principal is relatively insulated from shocks.
WACC for a given business is the discount rate that must be applied to its future cash flows in order to perform a DCF analysis.
How to calculate WACC
The simplest version of the WACC formula is as follows:
(Cost of equity x percentage of capital that is equity) + (cost of debt x percentage of capital that is debt)
Let’s illustrate this with an example. A company has a total capitalization of $100 million. Of that, 75% is equity and 25% is debt. The cost of equity is 5%, which is the hurdle rate shareholders require to justify owning stock in the company (they could get that return elsewhere if they wanted to). The cost of debt is 3%, which is simply the interest that must be paid on the company’s loans. So WACC comes out to:
(75% x 5%) + (25% x 3%) = 3.75% + 0.75% = 4.5%
Once you have a figure for WACC, you simply plug it into the DCF formula and get the discounted present value of future cash flows of that business. The higher the cost of capital, the less the future cash flows will be worth.
It must be added that this is not the full WACC formula - plenty of other variables may have to be considered, depending on the capital structure of the company. For instance, I have omitted preferred stock and tax considerations for simplicity.
What does this mean for investors?
OK, big deal, you may say. This may be of interest to the chief financial officer of a company, but I am not a CFO and, therefore, this does not matter to me. Not so. Investors can learn a lot about a company by how it uses the capital of its shareholders and creditors. If management is sinking capital into projects with limited return, that is not a good sign. Similarly, passing up on good opportunities to deploy capital is also not an indicator of capable management.
Make sure you derive an accurate discount rate for the businesses you are considering investing in. Remember that riskier investments will always have higher discount rates. This is something we intuitively understand, but can sometimes forget the reasoning for.
Read more here:
- How to Build a Discounted Cash Flow Model: The Basics
- Warren Buffett and Charlie Munger: Building a Circle of Competence
- Warren Buffett: Lessons From 6 Periods in the Stock Market
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