Hi all.

Does anyone here use the Weighted Average Cost of Capital, to work out the discount rate to use in valuing a stock? I've recently been looking at this, and am wondering if anyone finds it useful at all.

Brief outline, as I understand it:

A company's weighted average cost of capital is equal to the cost of their equity + the cost of their debt, weighted by the percent of the total capitalisation they make up. Anything a company does needs to have a return greater than their WACC for it to be worthwhile and earnings positive.

So to calculate it:

Work out their ordinary shares market cap, preferred shares market cap (if necessary), and total long term debt. Add them up for the total capitalisation, and work out what percent each of them are.

Then work out the cost of each. Preferred shares generally have a quoted yield, so that's their cost. The cost of long-term debt is equal to the interest rate on it, which I would usually get by averaging the (borrowing costs/debt) for the previous few years, although you could do this more stringently. The book I'm reading from then multiplies this by (1 - Tax Rate), because debt gives tax benefits. I suppose this is OK.

The cost of preferred stock is the hard one. The book I'm reading from takes the risk free return (say, 10-year bonds at 5.67%), and adds the beta of the stock times the equity risk premium (say, 3%).

As an example, here's one I just did for BPC:

Ord. Market Cap: $0.61*1.78b = $1.086b
Pref. Market Cap: $0.66*797m = $526m
Long-term Debt: $2.814b (Ouch...)
TOTAL Cap: $4.426b

Weightings: Ord - 24.54%, Prefs - 11.89%, Debt - 63.57%

Cost of ord stock: 5.67% + (2 * 3%) = 11.67% (Taking beta as 2, cause I haven't got a source for it.)
Cost of preferred: 7.5%
Cost of long-term debt: 8%*(1-30%) = 5.6%

WACC = 24.54%*11.67% + 11.89%*7.5% + 63.57%*5.6% = 7.32%

So the discount rate I'd use to value BPC is 7.32%, but this sounds a little low for my liking. It appears that debt's a lot cheaper than equity, by this method (5.6% as opposed to 11.67%, for BPC). Should that be so?

So, yeah, does anyone else use this? Any pointers on how I should use it? Am I correct in what I'm doing, so far?

Thanks, Bergholt.

G'day Bergholt,
I tried to come to grips with WACC some time ago but without success.

A site I visited which has a couple of links you may find helpful is

http://www.investopedia.com/terms/w/wacc.asp

Commsec have the Beta for BPC at .58 if that of any help.

Thanks, Pedro.

I quite like the WACC so far - I'm a bit of a numbers man and I've got a nice spreadsheet set up for it. All very pretty, but I'm not convinced that it's all that necessary. Is choosing a discount rate really all that hard? I suppose it's useful because it leads you to the returns that you should expect the company is aiming for, and so if you're looking for huge returns on your money you shouldn't invest in BPC with a discount rate of 7.32%, because that's all you're likely to get. I'm not convinced one way or the other, yet.

Thanks for the link, I finished reading that just before your post popped up. That site can be quite useful, although it doesn't go into much depth.

Incidentally, with the beta for BPC of .58, we get a WACC of 6.27%, which seems very low for my liking. This is definitely because of all their debt, but I can't quite extract a logical justification for this.

Bergholt.

G'day again Bergholt,

Good to see you found that site. Did you check out the two links at the bottom; they expand a bit more on it.

Notice you are trying to forecast what the company is aiming for and are not convinced the 7% odd the formula tells you is high enough.

Have you considered using the Rate of Return you require on a stock as the Discount rate and assessing the company's fundementals separately.

I do this as follows, after I am satisfied that the company I am considering has sound financial fundamentals.

1. Forecast Growth in EPS (GEPS) for next 5 years
2. From existing EPS work out EPS in 5 years time
3. Multiply this EPS by a forecast P.E. in 5 years time to get a forecast Price
4. Estimate Div Payout ratio and franking % over the period
5. Calculate the Dividends and franking credits available
6. Add Divs/franking credit to Forecast Price (3 above)
7. Using financial calculator put in total arrived at in 6 as Future Value
and show Required Rate of Return as the Interest Rate, 5 years as the term and hit Present Value.

The Present Value will be the price to buy at to obtain the Required Rate of Return if all my assumtions with regard GEPS , Div/Franking credits and P.E. come to fruition.

The Following thread “Pedro’s formulaeâ€

Thanks Pedro.

Yeah, it's interesting, that's roughly the method I've been using but I'm not completely satisfied with it. I think the main problem for me is that I'm worried about my predictions for future earnings growth - I tend to be quite optimistic when I look at a stock and then end up with a ridiculous price which they're never possibly going to reach.

So I've been using this WACC stuff with some DCF analysis, which I like a bit better, although it's quite complicated in many ways. I'm still trying to find a way which works perfectly for me.

As for the low WACC for BPC, well, I suppose I'm trying to find the intrinsic value of the company. If that's their cost of capital, then that's their intrinsic value, and what I would expect from them (a discount rate of closer to 12%) is not related to that.

Still learning, thanks, Bergholt.

G'day Bergohlt,

Estimating the growth of a company is never easy but a key is the sustainable growth rate which I outlined in thread at

http://www.sharesguru.com/forum/viewtopic.php?t=1724

This gives an idea of the growth rate , without borrowings, a company can achieve. Obviously with borrowings this can be increased if the market is there.

Personally I have found past performance , particularly a steadily increasing ROE over last 3 years is a good guide.
Have a look at the compound growth rate in EPS over a company’s past 5 years and 3 years and read company report as to their future prospects.

For a lot of companies it is very difficult because of uneven earnings and these are the ones I tend to leave alone.
Check out Commsec’s “Earnings Stabilityâ€

something I am tring to get my head around:

What is the Weighted Average Cost of Capital (WACC)?
What regulated infrastructure assets are, how they are regulated, and how regulated revenue is calculated. Central to the calculation of infrastructure revenue streams is the concept of weighted average cost of capital (WACC).
WACC is one of the most powerful and widely used tools in finance. It is used by equity analysts to place a value on companies, it is used by companies to decide on the merits of projects or acquisitions and whether an adequate return can be made, and it is used by regulators to apply an appropriate return on infrastructure assets.

WACC is based off the fundamental tenant of risk and return. At its most basic level, a company has two sources of funding, debt and equity. The WACC seeks to reflect an appropriate return required from the companies funding sources. As we know, equity is more risky then debt, and as such, investors in equity expect a higher return on the funds they provide to a company. Debt is less risky, and as such generally receives (or is expected to receive) a lower return.

There are many varied sources of funding within the broad headings of debt and equity (senior debt, subordinated debt, hybrids, preferred shares, ordinary shares to name a few) each with their own required returns, but for the sake of simplicity, we will stick to the basic debt and equity.

Let us assume that the required return by equity investors (who wear more risk in the company’s performance) is 12% and the required return by debt investors (who wear less risk in the same company’s performance) is 8%. We can’t just take the average of these two and assume the required return for the company is 10% as this fails to reflect weight of contribution the two funding sources make towards the company as a whole.

Companies are rarely funded by a straight 50:50 split between debt and equity (or else the basic average – 10% in our example – would be correct to apply). We need to reflect how much debt makes up the total funding of the company, and how much equity makes up the funding of the company, this is the weighting in WACC.

If a company is geared to 60% this means that 60% of total funding (debt + equity) is sourced from debt, and thus 40% from equity, so the total required return would need to be weighted to reflect this.

Regulators reach what they deem is an appropriate WACC for an infrastructure asset via consultation with the assets’ owners and other stakeholders and by comparing it to its peers from Australia and around the world. So after this process, the regulator will determine the appropriate efficient return for the particular infrastructure asset (in the example 8.16%) and this will be applied to the value of the asset to derive a revenue return on the regulated assets’ capital value. So if the regulator has approved a value of $1bn for a gas pipeline, and the determined WACC is 8.16%, then the owners will receive $81.6m per year over the regulatory period for the use of the assets (remember that they also receive revenue to cover operating expenses and depreciation on top of this).

How do companies outperform the regulated return?

Infrastructure companies, like any other, seek to outperform and increase their returns to shareholders. They are able to do this by ‘beating’ the assumptions the regulator makes when it is determining its regulated revenue. The regulator makes assumptions about the efficient level of operating expenditure to maintain the assets, so if the company can maintain its assets for less cost, it is able to outperform the regulated allowance. Conversely, if they are unable to match the regulators allowances, and underperform, they can place dividends and interest payments at risk.

Infrastructure companies also seek to outperform the regulated WACC and they do this by increasing the level of debt. If you increase debt gearing to 80% and thus lower equity contributions to 20%, equity investors are able to achieve higher return. This is achieved, all else being equal, by sharing the same return over a smaller pool of equity investors.

Benthonic,
I have never been able to get my head around WACC either,

This article might explain it but too iffy for me.
http://www.investopedia.com/articles/fundamental/03/061103.asp

The final paragraph is on the money though

Be warned: the WACC formula seems easier to calculate than it really is. Just as two people will hardly ever interpret a piece of art the same way, rarely will two people derive the same WACC. And even if two people do reach the same WACC, all the other applied judgments and valuation methods will likely ensure that each has a different opinion regarding the components that comprise the company value.