WACC explained

WACC explained


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. Want to learn more about business, finance,
accounting and investing? Then subscribe to the Finance Storyteller
YouTube channel, and start watching the next video in the recommendations on the screen. Thank you.

3 thoughts on “WACC explained

  • January 28, 2020 at 9:05 pm
    Permalink

    If you go to the Netherlands will you have to pay a BTW?

    Reply
  • January 29, 2020 at 9:08 am
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    Pseudo science! Proper wake up call for all of us

    Reply
  • January 31, 2020 at 2:23 pm
    Permalink

    Perfectly clarified. Had to rewind a few times for clear understanding (it doesn't cross my path everyday) but yeah….'floods' happen so outcome could potentially be arbitrary.

    Reply

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