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The WACC is perhaps the most important and the most elusive metric in company valuation.
When it comes to valuing companies for investment, the most popular method is the discounted cash flow (DCF) method. The DCF, which we will cover only briefly in this article, uses the WACC, which is a proxy for the cost of capital for a company.
In the following article, we will explore what the WACC is, how it can be calculated, where it is used, and the things you must keep in mind when calculating it.
What is the WACC?
The WACC is a metric that’s used to gauge a company’s overall cost when it wants to raise funds to operate its business. Expansion requires capital, which companies can raise in two ways: either by taking on debt from banks, financial institutions, or bonds; or by selling equity shares to investors.
Obviously, when investors lend this capital to the company, the latter has to pay a price for it, either in terms of an interest payment or a return on capital. This payment is what is referred to as a cost of capital for the firm.
Interest payments, which is the cost of debt, and the capital appreciation or dividend payments, which is the cost of equity, are both components of the WACC.
When we combine both these costs into one metric and weigh them according to how much each one of them should be, we get to the WACC.
Overall, the WACC provides an integrated overview of the obligations of the company when it comes to raising and paying back capital, and the decisions it must make about growth, capital allocation, and investments accordingly.
Calculating the WACC
From the previous section, you must have a rudimentary understanding of what the WACC is. Now, we must calculate it using actual numbers.
Here are some components of the formula you should be familiar with first:
- Market value of the firm’s equity – This is what the entire equity of the company should be worth. For a public company, this is the total outstanding market cap.
- Market value of the firm’s debt – This is all the debt obligations the company has on its balance sheet (both current and noncurrent).
- Cost of debt – This is the percentage cost the company has to pay on the above debt. Usually, this cost of debt is lower than the cost of equity.
- Cost of equity – The cost of equity is the return equity investors demand from the company in return for their capital. This is usually calculated using the capital asset pricing model (CAPM). Investors usually demand a higher price for equity investments than debt investments simply because equity is more risky.
- Corporate tax rate – The percentage amount of taxes the company has to pay, overall, to the government. This is calculated because interest payments on debt usually have a tax shield that helps companies save money.
- Total value – Total value is simply a sum of the total market value of equity and the total market value of the debt of the company.
WACC formula
Here’s how everything comes together in the formula:
WACC = (Equity / Total Value) * Cost of Equity + (Debt / Total Value) * Cost of Debt * (1 – Tax Rate)
Simply place all the above numbers, which you calculate beforehand, into the formula to come up with a percentage expression of the WACC.
Understanding the complexity of the WACC
While the WACC formula itself is hardly complicated to apply, the issue is the assumptions. When estimating the value of a company for investment, most investors have to estimate how much money the company will make in the future and discount them to the present value. This discounting happens with the WACC.
Not only does that estimation of future profits have a lot of presumptions, the WACC does too. This is the reason why valuations are not an exact science – they are opinions. They can differ from person to person depending on their personal assumptions about the company’s future growth and its cost of capital (which is the WACC).
Frequently Asked Questions
In most cases, no. A lower WACC usually signals to investors that the business is less risky. A higher WACC also discounts future value by a higher amount, which means current valuations become smaller. A lower WACC tends to correlate with more stable businesses.
Since the cost of debt is usually smaller than the cost of equity, most businesses find their operations and expansion using bank debt, which tends to lower their WACC. However, this often makes the business more risky too.
WACC is very sensitive to calculation assumptions, and hence it might not sometimes give an accurate picture of the company’s cost of capital. Calculation itself can also be complex sometimes, especially for companies that operate in very volatile industries.
This is because the cost of debt has to be multiplied with the amount of debt the company has, proportional to its size. This is also the case with the cost of equity. The debt or equity to total value represents each metric’s weight in the company – hence, the weighted average cost of capital.
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