The Phaserl


The Weighted Average Cost Of Capital

When it goes up, prices go down. It’s going up…

by Adam Taggart, Peak Prosperity:

When I was fresh out of college in the mid-90s, I landed a job at Merrill Lynch. I was an “investment banking analyst”, which meant I had no life outside of the office and hardly ever slept. I pretty much spoke, thought, and dreamed in Excel during those years.
Much of my time there was spent building valuation models. These complicated spreadsheets were used to provide an air of quantitative validation to the answers the senior bankers otherwise pulled out of their derrieres to questions like: Is the market under- or over-valuing this company? Can we defend the acquisition price we’re recommending for this M&A deal? What should we price this IPO at?

Back then, Wall Street still (mostly) believed that fundamentals mattered. And one of the most widely-accepted methods for fundamentally valuing a company is the Discounted Cash Flow (or “DCF”) method. I built a *lot* of DCF models back in those days.

I promise not to get too wonky here, but in a nutshell, the DCF approach projects out the future cash flows a company is expected to generate given its growth prospects, profit margins, capital expenditures, etc. And because a dollar today is worth more than a dollar tomorrow, it discounts the further-out projected cash flows more than the nearer-in ones. Add everything up, and the total you get is your answer to what the fair market value of the company is.

The Weighted Average Cost Of Capital

The DCF approach sounds pretty straightforward. And it is. But it’s still much more of an art than a science. Your future cash flow stream is entirely dependent on the assumptions you bake into the model. The difference between a 5% or 15% assumed EBITDA compound annual growth rate becomes huge when projecing over 10+ years.

But one assumption in the model has far more impact on the final valuation number than any other. And it has nothing to do with the company’s projected operations.

Recall that the DCF approach projects out the expected future cash flows, and then discounts them (back to what’s called a “present value”). This raises a critically important question:

At what rate do you discount these future cash flows?

Well, to address this, you need to ask yourself a few questions. How will the company be financing itself? It will need to deliver an acceptable return to both its stockholders and bondholders. What kind of return can investors get out in the market for a similar investment? If they can get a better expected rate of return, or similar return with less risk, they’ll put their money elsewhere.

Enter a calculation known as the Weighted Average Cost Of Capital (or “WACC”). Again, without getting too technical on you, the WACC looks at how a company is capitalized (what % with debt, what % with equity) and what blended annual rate of return the investors who contributed that capital expect. Once you’ve calculated the WACC, you put that number into your DCF model as the annual discount rate and — Voilà! — your model spits out the present value for the company.

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