WACC on the Buyside

Is it common for the buy side to just use 10% as the discount rate without doing a WACC analysis? I've seen a few posts saying they just use 10% as a base and 15% as a bear case. I understand WACC is an academic approach but wouldn't ignoring a WACC analysis ignore companies that have different capital structures, companies that can take advantage of cheap debt financing, etc. Anyway I'm just wondering if it's really that common for analysts on the buy side to just use 10% as their discount rate and call it a day

Comments (14)

Aug 26, 2020 - 2:20pm
Acidophilus, what's your opinion? Comment below:

Using a 10% discount rate gets you the price at which you'd earn a 10% IRR. Using a 15% discount rate gets you the price at which you'd earn a 15% IRR. It's just a way of saying what kind of return hurdle do I want to underwrite to, and at what price does it make sense for me to purchase the stock given that return hurdle. For a riskier stock (or if you just want greater margin of safety), you might say I want to earn 15% to compensate for that incremental uncertainty, so you use 15% and your target buy price goes down.

I believe Warren has mentioned he uses a 6% discount rate (or 10 year treasury yield, whichever is higher) to find his "fair value" price. Of course, he is not actually buying at fair value (which would earn him just a 6% return) because he can just go and buy the market otherwise. So he would probably use a discount rate like 10% or more to find his buy price.

In practical terms, there are some teams (at MM) that don't even use discount rates. Just forecast NTM earnings and slap on a multiple (which has an implicit discount rate baked in, but not too much thought is spent on that) based on historical ranges.

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Aug 26, 2020 - 11:23pm
Secyh62, what's your opinion? Comment below:

It really is going to depend on the shop, and even the analyst, as to what they believe and do. Using an arbitrary WACC is not a practice that I would recommend. Discount rates and risk premiums, like markets, are not static and change over time. Additionally, as you mentioned, companies have different capital structures and different levels of risk. The cost of capital should be reflective of current market conditions, the idiosyncratic risks of the business, and the risk appetite of investors. Obviously, the variable that everyone is uncomfortable with right now is the RF rate (70 BPS if you're using the 10-year, could also argue that the market implied ERP is relatively low at the moment as well). Using anything other than the current RF rate however, is implicitly a macroeconomic forecast, and fundamentally a variable that should drive asset allocation decisions rather than individual security selection. Using a higher RF rate is akin to saying the market is mispriced because investors have discounted it at an unsustainably low RF rate. In that case, you should bet on the asset class of equities rather than individual securities which will undoubtedly all be affected by a higher RF rate (this is why interest rates are a systematic variable). You could argue (correctly) that longer duration assets (growthier companies) are more sensitive to changes in interest rates, and that it is reasonable to reflect that sensitivity in your security selection, but still, you are implicitly forecasting a macroeconomic variable in choosing lower duration assets for the sake of this sensitivity consideration (you wouldn't be concerned about the sensitivity if you were not expecting higher interest rates). The thing about macro forecasts, is that not many are very good at them, especially analysts focused on more narrow segments of the economy. For the most part, as analysts, what we are after is whether or not the market has correctly priced an individual security, not whether or not an entire asset class is correctly priced, and as such, we should leave views on macroeconomic variables out of valuation, and accept the market and these uncertainties as they are given.

Now the above only applies to if you are trying to estimate a true fair value with economically sound principles. As Acidophilus mentioned, you'll find that most still rely on multiples and have no idea what ROIC, growth, or WACC the multiple they used implied. In practice, from my discussions with others at large funds that most on this board would like to work at (long-only specifically), multiples are still the standard and a detailed DCF is rarer to come across. For that reason, I think having a robust valuation discipline can be a source of edge, given that so many still operate using the shortcut of multiples, and given how important valuation is to investment results.

I'll add one more thing here, if you do have the ability to raise cash in a portfolio, then thinking about the discount rate as more of a required return relative to your personal risk tolerance is valid. Meaning, if a 10% return is what you are comfortable with, use a 10% return. But in this environment, that would most likely push you into cash, as the market in aggregate has been discounted at a much lower rate at present, and most analysts cannot go back to their PM and say we must go to cash or short everything.

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Aug 28, 2020 - 1:03am

Sidenote to the WACC discussion - if you think the RF rate is unsustainably low and will come up, shouldn't you be short equities as an asset class not long equities, given that higher RF rates will increase discount rates and decrease valuations. 

on the WACC thing - I don't think I've ever actually used the WACC calculation to arrive at the discount rate in any of my jobs besides in banking. We'll do DCFs using discount rates that we feel appropriately reflect risk premia but I've never gone as academic as to use a WACC to derive that figure. At some point things that are too academic I feel become useless for the reality of the market - but then again i'm sure there's some great algos that use WACC and all the academic principles of finance to make money and I'm an idiot. 

Aug 28, 2020 - 8:59am
Secyh62, what's your opinion? Comment below:

Yes if your expectation is for interest rates to rise, it would be a reasonable idea to short equities or to raise cash. My point was that as analysts, our job is to identify undervalued securities and net exposure is going to be more of a PM-level decision. Additionally, I have never met or read about anyone who is good at forecasting macroeconomic variables (though I'm sure some exist, they are rare). 

I'll reiterate that the reason most in equity markets dismiss DCF's as their primary tool, or a useful tool at all, is because they do them incorrectly and they get results that don't make sense in the context of current market prices (the carpenter blaming the hammer for a poor end-product). Given that it is so rare to see a DCF built correctly, and given the pressure to conform to industry standards, I can't blame anyone for thinking that way or defaulting to multiples-based valuations. But if you want to produce differentiated results, you have to do things that are different. If you believe in the premise that a security is the value of its cash flows discounted back to the present for the time value of money and risk of those cash flows, than using multiples is implicitly discounted cash flow valuation, just without an understanding of the components of said multiple. I personally started off using multiples and have moved on to more detailed valuations. I couldn't tell you the PE of a single name in my coverage right now. As I said in my other response, I think that having a robust valuation discipline can be a source of edge. Multiples are really just a shortcut for DCFs, but given the importance of valuation to investment results, why take a shortcut on such an integral part of the investment process? The WACC is one of the most important components of the valuation, and one where discretion can be completely removed, so I wouldn't take any shortcuts there either.

Aug 28, 2020 - 12:25am
dickthesellsider, what's your opinion? Comment below:

All great answers, but I think if the decision to take a position hinges on difference between 5% WACC or 7% WACC, there is no thesis there. Of course it does matter when deciding between WACC of 2% versus WACC of 20%, but I'd still spend bulk of the time on assessing the fundamental and realiz-ability of future cash flows. 

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Aug 30, 2020 - 2:51pm

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