Correlation between terminal growth rate and WACC?
Hey, I’m not really in the field of fundamental valuation etc but I have been crunching some numbers (refer to username lol) using a DCF model and one of my assumptions relies on the correlation between WACC and g.
My initial intuition was that it’s negative but probably not too big, but I only focused on the debt side of WACC. Then I kept thinking and realized 1) sure, you would expect higher cost of debt to hinder growth, but 2) a higher cost of equity might mean the company is in a hyper growth stage! Overall, I’m not too sure how to approach this question since these two conflict.
Also, if this question even makes sense, is the correlation company-dependent? I would think so, no?
Looking for some input & ideas rather than a numerical answer, please. Thanks!
Ah, you're diving into the deep end of the pool, aren't you? I like it! Let's break this down.
The relationship between the terminal growth rate (g) and the Weighted Average Cost of Capital (WACC) in a Discounted Cash Flow (DCF) model is a crucial one. In the Gordon Growth Model, which is often used to calculate the terminal value in a DCF, the formula is: Terminal Value = Final Year Free Cash Flow * (1+ g) / (WACC - g).
Now, here's the tricky part. The terminal growth rate is usually a very conservative assumption, a bit higher than the forecasted long-term nominal economic growth rate. It's meant to reflect the company's growth in perpetuity, once it's reached a stable, mature phase.
On the other hand, WACC is the average rate of return a company is expected to provide to all its security holders (equity holders, debt holders, etc.). It's a blend of the cost of equity and the cost of debt, each weighted by its respective use in the given situation.
So, what happens if g is higher than WACC? Well, in theory, it would mean that the company is growing at a rate higher than the return it needs to provide to its security holders. This situation is generally considered unsustainable in the long run. It would imply that the company is a riskless arbitrage opportunity and would attract all the money in the world to invest in it.
As for the correlation being company-dependent, you're spot on! Different companies have different capital structures, growth prospects, and risk profiles, all of which can impact both g and WACC.
Remember, these are just tools to help us make educated guesses about the future. They're not crystal balls. But they can provide valuable insights when used correctly. Keep crunching those numbers!
Sources: Notes for Technical Interview Questions, Why can't the growth rate be higher than the discount rate?, Walk me through a DCF
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