Compared to the academic approach of calculating WACC, what is the approach that banks use to calculate WACC in the real world? I understand different banks may have different approaches to their calculation, so it would be helpful to understand different approaches
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Here is the truth to all valuations, the valuation will be whatever the MD says it will be and it will be your job to be cunning enough to create some bullshit model that is plausible to support the MDs valuation so he doesn’t fuck up the pitch. also public targets start with comparables WACC and private targets throw up 20%
It's low enough to win the pitch and high enough to not get called out for being a moron.
This, this is it.
doesn’t matter what approach you use it’s always 10%
In addition to what has been said (which is true): Rf: 20y gov bond or 10y/20y average of 10y/20y bond (to get it to at least c. 2%) Beta: Bloomberg peergroup -> play around with time/frequency until you get a beta that suits the ERP you are looking for ERP: normally every bank has 1 source they alwasy use (e.g. Damodaran) Debt: check outstanding 10y bonds or just take 3%-ish
US might have different appraoch
In sell side pitch it often is c. 8% for normal companies (i.e. not REIT/biotech/etc)
So it's pretty clear to me now that on the sell side you are just coming up with a WACC to defend the MD's valuation. How does this differ compared to the buy side?
I'm not sure if your question is on the exact methodology for the calculation of WACC, or if this is more of a theoretical discussion. I will choose the latter.
What is WACC really? I think of WACC and its sister IRR as risk. Pricing in the risk to an investment or purchase. For valuation purposes, when modeling a DCF/LBO, the amount of risk vs return associated with the target business should be reflected in the WACC/IRR. Since, the modeling is based on the intrinsic value of future cash flow, the main source of risk arises from the ability to meet financial projections. e.g. if the target's financial projections are the classic hockey stick with a high CAGR, you should increase the WACC/IRR as there is a higher amount of uncertainty to obtaining that level growth over the projection period.
Another example from the PE side for pricing in risk would be adding a "buffer" percentage to the IRR during modeling. For example, say your PE firm has a target IRR of 20% for a new platform investment. To help price in the risk of the investment you can have the IRR be 22.5% (2.5% over the target IRR), this would lower the entry valuation of target or lower the amount of money you would pay to acquire the company. And if all goes to plan and financial projections are met, the firm will have an above target return on that investment. But, if the company grows slightly less than that, and they could still hit their IRR target.
This may be to detail of a point especially if you don't understanding LBO modeling, but that is a basic summary of the theory as to how WACC and IRR are used as a tool for determining the purchase value based on potential risk factors.
Never play around with discount rate percentages to adjust for risk Adding 1% to your Wacc or 2.5% to your IRR is not a lineair function. Some companies cant cope with -20% revenue for instance and go bankrupt. Value = 0 instead of -20% in that case.
If you want to price in risk: identify and quantify it properly. Make an additional case in which the risk materialises and assign a probability to that case. Take the probability weighted valuation of your cases and you have priced in your risk.
Fair point, risk is most likely the wrong terminology. But, my point was relating to the correlation between enterprise value (or the purchase multiple) to the investment's future performance. I thought the OP wanted the real world example.
Out of curiosity, do you and your firm model out a LBO with a set IRR and then use sensitivity analysis on revenue to determine the valuation for an IOI or LOI? I would like to hear more about your process, is it a sensitivity analysis of revenue growth CAGRs or IRRs?
Please and thank you
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