Valuation Primer - Part 3 - WACC
In the last primer, I went over using a DCF. A major component in deriving a company’s value using a DCF is the WACC. Although many of us on WSO know how to create a WACC in our sleep or have memorized the formula, I know some monkeys still do not fully understand the pieces which make it up, in particular the components of the cost of equity and cost of debt. To all college students, interns, and new hires, please read and review the attached model to learn the different ways to derive the weighted average cost of capital. I will show how to build a WACC using the build-up method and CAPM. This article is meant for monkeys with a little to no understanding of WACC.
A company’s assets are financed either through equity or debt. In order to acquire assets (cash, inventory, fixed assets, etc.), you can either sell equity (a stake in your company) or finance it through debt (a loan from the bank). This article will not go in-depth regarding WACC theory, rather, reviewing the models provided will hopefully help college monkeys understand how a WACC is built in the real world.
The WACC formula is as follows:
WACC = E/V *Re + D/V * Rd * (1-Tc)
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Hopefully after reviewing the attached models, this formula will be more intuitive.
Build-up method
The WACC is made up of the cost of equity and the cost of debt. In both models, these are separated out. The factors which go into the build-up method for the cost of equity (CoE) include the risk-free rate, equity risk premium, size premium, and company specific risk premium. Some models will also include an industry specific risk premium.
Risk-free rates can either be normalized for a period of time or the risk-free rate as of the date of your valuation. Risk-free rates can be found through the Federal Reserve website. Equity risk premiums, size premiums, and industry specific risk premiums are all found in Ibbotson’s SBBI Valuation Yearbook, which is updated each year. Company specific risk is determined by the valuation analyst and includes various factors. The combination of these will give you the cost of equity.
Modified CAPM
The modified CAPM is very similar to the build-up method. The only difference is the need for publicly-traded comparable companies to derive a beta. The median beta of your publicly-traded companies will be used to multiply your equity risk premium (from SBBI Yearbook) and then add the risk-free rate, size premium, company specific risk premium, and industry risk premium to determine the cost of equity.
Cost of debt
Depending on the credit rating of your subject company, you will determine the cost of debt. Typically, the Moody’s Baa rate is used as a default (at least for the organizations I have worked for, please correct me if I am wrong). This rate can also be found on the Federal Reserve’s website. Due to tax benefits, you will need to multiply the pre-tax cost of debt (Moody’s Baa rate as of that date) by 1 minus the subject company’s rax rate. The resulting percentage will be the cost of debt.
Capital Structure
Capital structures should be determined through the typical company in the industry. This can either be determined through guideline public companies, or other private company databases. The selected percentages will be multiplied by each respective cost, and then combined to determine the weighted average cost of capital.
The next part of the primers will include net working capital analysis, market approach, option pricing models, and more.






Comments
Thanks, man!
Thanks, man!
RIP WSO Chat.
yucky font
yucky font
focus: yucky font haha I
yucky font
haha I knew I was going to get a comment on that. Feel free to change fonts.
See my other WSO blog posts
valuationGURU: focus: yucky
yucky font
haha I knew I was going to get a comment on that. Feel free to change fonts.
Thanks valuationGURU - great stuff.
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What no Modigliani–Miller
What no Modigliani–Miller theorem??
Fear is the greatest motivator. Motivation is what it takes to find profit.
Wanna know how I decide what
Wanna know how I decide what WACC to use? I scratch my head for two seconds, then use 10% for my base case and 15% for my low case.
No one on the buyside spends time thinking about "WACC" ... please. Just another one of those dumb academic concepts.
Is it horrible to go to
Is it horrible to go to bloomberg and take the average weighted costs for pref eq, eq, debt and solve that way?
Mel Clark: Is it horrible to
Is it horrible to go to bloomberg and take the average weighted costs for pref eq, eq, debt and solve that way?
Never heard of that done in a professional setting but I could be wrong. Anyone else know?
See my other WSO blog posts
Holy s.hit, cost of capital
Holy s.hit, cost of capital 18%? Is that some small-cap pharmaceutical company, lol? (not srs). Nice blog post. What do you have next in mind?
The difference between successful people and others is largely a habit - a controlled habit of doing every task better, faster and more efficiently.
mhurricane: Holy s.hit, cost
Holy s.hit, cost of capital 18%? Is that some small-cap pharmaceutical company, lol? (not srs). Nice blog post. What do you have next in mind?
Net working capital analysis, market approach, option pricing models. Just depends on how much time I have after work this next week. Any suggestions besides the three?
See my other WSO blog posts
Mel Clark: Is it horrible to
Is it horrible to go to bloomberg and take the average weighted costs for pref eq, eq, debt and solve that way?
I would only use Bloomberg to verify and spot-check your numbers. They have a tendency to be outdated and wrong. If you have a DCM team it might be beneficial to just give them a call and try to work out the equity yourself...
Really solid post valuationGURU. Looking forward to more in this series.
a primer this is. risk free
a primer this is. risk free rate itself alone is worth a 10 page discussion let along equity risk premium and all those other junk.
but i digress. academia is very different than irl. dcf in real life is more like your analyst/md setting the price target and then have you fiddle around the model to make it fit with numbers that makes sense.
vitaminc: but i digress.
but i digress. academia is very different than irl. dcf in real life is more like your analyst/md setting the price target and then have you fiddle around the model to make it fit with numbers that makes sense.
Sure ... when you're a sell side pitch monkey.
I'm having problems coming up
I'm having problems coming up with a WACC ,I feel like its way to low, I keep getting around 7%. Can someone tell me what I'm doing wrong?I used a risk free rate of 2% which is higher than the yield on the 10 year, which is what you are supposed to use. The company has a beta of 0.34, I didn't unlever and relever it as the company has no debt and the only other publicly traded comparable also has no debt so i didn't think it was necessary. I used a risk premium of 15% which I feel is super high, considering I was under the impression that 6%-7% was the norm. Should I just leave it or what?
NewGuy: vitaminc: but i
but i digress. academia is very different than irl. dcf in real life is more like your analyst/md setting the price target and then have you fiddle around the model to make it fit with numbers that makes sense.
Sure ... when you're a sell side pitch monkey.
Did your PM ever strike down a stock pitch just because its WACC doesn't make sense?
Not sure on the PE side, but do people actually talk about WACC during negotiations?