Weighted Average Cost of Capital, in short WACC.
This seems to be one of the most intimidating concepts in finance.
Fear not, this video explains WACC in an easy to understand way.
We will cover: what WACC means, how WACC is used, how WACC is calculated in the WACC formula,
and why the WACC formula is pseudo-science, in other words: of questionable value and
potentially dangerous.
What does the acronym WACC stand for?
The WACC is the Weighted Average Cost of Capital.
Weighted Average indicates that we are going to apply some mathematics to get the proportions
right, and Cost of Capital indicates an attempt to identify the cost of various types of capital.
WACC is a calculation of a firm's cost of capital in which each category of capital
is proportionately weighted.
The WACC is often used to try to answer the fundamental question in life for both investors
and businesses: can we create value?
Here’s a diagram of value creation for both investors and businesses.
On the left: an investor and a bank.
They invest a significant amount of money in securities: buying shares in a company
(equity) or supplying a loan to a company (debt).
It’s their hope, at some point in the future, to get a bigger bag of money out of the investment
than what they put in.
The money that the company has now raised gets invested in the company’s operations
(its assets).
Same idea here: at some point in the future, the company aims to get a bigger bag of money
out of the investment than what was put in.
Another comparison we can make is between the return on the assets (on the right) of
the company versus the return on the capital of the company (on the left).
How do investors identify the potential for creating value?
Here’s what many equity investors (or their analysts) would do.
They try to forecast the future for a complex financial metric called Free Cash Flow, and
then apply Discounted Cash Flow analysis.
Let’s take that step by step.
Free Cash Flow is a function of other financial metrics such as revenue, margins, working
capital, and capital expenditures.
To learn more about how Free Cash Flow works, watch the related video.
Let’s focus on the WACC part in this video.
The solid blue line represents the historical actual results, the dotted line the forecasted
Free Cash Flow.
The black vertical line is today.
The formula at the bottom is what the equity analyst is trying to fill.
The value of a company today (indicated by V0 in the left of the formula) is seen as
the cash that the company currently has (C0 in the formula) plus the estimates of future
Free Cash Flows discounted back (using the Weighted Average Cost of Capital) to their
present value. That’s where the WACC gets used.
Put the Free Cash Flow estimate for year 1 in the numerator, divide by one plus the WACC.
Put the Free Cash Flow estimate for year 2 in the numerator, divide by one plus the WACC,
to the power two.
Put the Free Cash Flow estimate for year 3 in the numerator, divide by one plus the WACC,
to the power three. And so on.
The next step for the analyst is to use the enterprise value that he calculated in his
model as the starting point for the estimated value per share of the company.
Enterprise value minus outstanding debt is equity value.
Equity value divided by the number of shares outstanding gives a model value of what a
share in this company could be worth.
This model value (based on assumptions and estimates) is then compared to the actual
share price out in the real world.
If the model value is $36 and the actual share price is $42, then the analyst would recommend
to sell the share, or even go one step further by shorting it.
You could earn $6 by shorting (or avoid losing $6 by selling) if the actual share price starts
behaving like your model!
If the model value and the actual share price are the same, then do nothing (“hold”).
If the model value at $36 is higher than the actual share price at $30, then the analyst
would recommend to buy the share.
You could earn $6 if the actual share price starts behaving like your model!
Market transactions based on this advice could then make the model value (which the analyst
believes is the “correct” one) and the market value converge.
Assuming that the world stands still and nothing unexpected happens, of course.
Let’s catch our breath for a moment [AUDIBLY EXHALES], and zoom out to put this in perspective.
A company tends to be followed by multiple analysts, representing different banks or
investment funds.
In the case of this specific company, twenty-two analysts
have done their forecasting and financial modeling.
If they do this at the same point in time, using the same information, and assuming similar
levels of spreadsheet skills, how come their conclusions are so vastly different?
Recommendations run all the way from “strong buy” to “strong sell”, and anywhere
in between, making the whole exercise potentially useless.
How is WACC used in companies?
Mostly in Net Present Value calculations for investment projects.
Here’s a project with $1000 investment today, and expected benefits of $400 per year for
the next four years.
Those future values of $400 per year get translated to today’s equivalent by putting the WACC
in the denominator of the present value equation.
The further into the future the $400, the lower the present value equivalent.
Repeat this calculation for all the years in the scope of the project, and then add
up the five numbers to get the NPV.
The regimen to create value in the corporate world: accept projects with NPVs bigger than
zero, reject projects with NPV below zero.
In essence, the same method as the equity analyst uses to value the company as a whole,
but applied to a specific project.
So how does the infamous formula work to calculate WACC?
Here’s the simplest version of it, assuming just two classes of capital: debt and equity.
WACC equals the market value of a firm’s debt divided by the market value of debt and
equity, times the cost of debt, plus the market value of a firm’s equity divided by the
market value of debt and equity, times the cost of equity.
Remember the definition of WACC: a calculation of a firm's cost of capital in which each
category of capital is proportionately weighted.
So this thing about debt divided by debt plus equity, and equity divided by debt plus equity,
takes care of getting the proportions weighted.
The multiplication is with cost of debt in the first part, and cost of equity in the
second part.
Let’s illustrate this with a WACC example of a fictitious company.
Debt is $250 million, out of total capital of $1 billion, so 25%.
Cost of debt is 4%.
Equity is $750 million, out of total capital of $1 billion, so 75%.
Cost of equity is 16%.
Multiply, and then add up, and you get to a WACC of 13%.
So where does this cost of debt, and cost of equity, come from?
The first part is fairly easy to grasp.
The cost of debt equals the interest rate that the company pays on its interest-bearing
debt, minus the tax benefit of interest expense being deductible.
So if the interest rate is 5%, and the corporate tax rate 20%,
then the after-tax cost of debt is 4%.
Then comes the more challenging part: cost of equity.
At this point, I hope you’ll say “what do you mean, cost of equity?
Isn’t the whole idea that equity holds no legal obligation for the firm to pay anything?”
No, says the economist, you should look at the opportunity cost of the equity capital.
An investor doesn’t have to invest in this company if he doesn’t want to, he could
earn a return elsewhere.
Cost of equity is therefore a required return by shareholders for the risk they take by
investing in this specific equity.
And that’s where the whole idea goes off the rails, as we start using historical statistics
to predict the future, basically fitting a line to past data hoping that this has any
semblance to what the future might hold.
This is what the CAPM (Capital Asset Pricing Model) prescribes: the required rate of return
on equity equals the risk-free rate plus a market risk premium multiplied by a measure
called β. Let’s take that step by step.
β represents some historical level of sensitivity of a specific stock to market movements.
Low β means: the individual stock is unusually insensitive to market movements.
High β: the individual stock is unusually sensitive to market movements.
Let's view that in a graphical way: β on the horizontal axis, expected (or required)
return on the vertical axis.
The higher the β, the higher the expected return.
Economists then introduce the term risk-free rate to indicate the lowest point: the return
on treasury bills, government debt.
They then introduce market risk, which is the average beta of stocks, and give it the
value 1.
The difference between the risk-free rate and the market risk is the market risk premium.
The expected risk premium varies in direct proportion to beta.
Sounds reasonable and plausible, right?
Here are the main reasons why I think WACC and more specifically the underlying CAPM
model that cost of equity is based on is pseudoscience.
You heard it right. Pseudoscience.
Questionable or potentially dangerous claims and practices.
First issue in the CAPM: the notion of “risk-free”.
Risk-free should be defined as 0% risk.
No risk whatsoever. An absolute certainty.
A guarantee.
A very safe security (like treasury bills) is very low risk.
However, very low risk is not the same as 0% risk, it is above 0%.
Remote and unlikely, yes, but impossible, no.
Read some accounts of government defaults and economic crises to see what happened to
debt labeled “very safe”.
Second issue: Historical covariance is no guarantee for the future.
More specifically: extreme events are more common than a normal distribution would imply.
Reading “The Black Swan” by Nassim Taleb will fully clarify this point.
This is intuitively obvious for people living near the sea or near a river.
The record flood level so far is no indication and certainly no guarantee of potential flood
levels in the future.
It can easily be surpassed, and not by just a little bit.
Why do most people understand this for nature, but fail to understand it in the context of
the stock market???
Let’s take this β, the historical level of sensitivity of a specific stock
to market movements.
General Electric, a very well-known company with a long history,
is said to have a β of 1.2.
The stock is supposed to move largely in line, with the overall market.
Here’s a graph of GE’s share price percentage change versus the S&P 500 market index for
2009 through 2016.
GE stock exhibits similar patterns as the overall market.
Here’s the same graph for 2019.
A bit of a dip in the late summer and early fall for the specific stock, but if you look
at start of the year and end of the year levels, and the overall pattern, reasonably similar
to the overall market.
Here’s the point: the “normal patterns” don’t matter if extreme events occur.
In 2017 and 2018, the overall market continued to rise, while GE’s share price dropped
like a stone, as the hidden risk that had been building up over the years came out and
the company’s financial results were hugely disappointing.
Very few shareholders of GE care about the statistical β, it’s the outliers, the extreme
events, that define the return.
The WACC is the Weighted Average Cost of Capital.
WACC is a calculation of a firm's cost of capital in which each category of capital
is proportionately weighted.
It sounds like a plausible idea, but has a lot of real world issues in its application.
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