When market indices soar to ever dizzying new highs and seem divorced from reality, it's time to get back to the fundamentals. Specifically, it's time to look at a key aspect of share valuations: the weighted average cost of capital (WACC).

### Key Takeaways

- The weighted average cost of capital (WACC) tells us the return that lenders and shareholders expect to receive in return for providing capital to a company.
- For example, if lenders require a 10% return and shareholders require 20%, then a company's WACC is 15%.
- WACC is useful in determining whether a company is building or shedding value. Its return on invested capital should be higher than its WACC.

## Understanding WACC

A company's capital funding is comprised of two components: debt and equity. Lenders and shareholders expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debtholders. So WACC tells us the return that both stakeholders can expect. WACC represents the investor's opportunity cost of taking on the risk of putting money into a company.

To understand WACC, think of a company as a bag of money. The money in the bag comes from two sources: debt and equity. Money from business operations is not a third source because, after paying debt, the cash left over is not returned to shareholders in the form of dividends, but is kept in the bag on their behalf. If debtholders require a 10% return on their investment and shareholders require a 20% return, then, on average, projects funded by the bag will have to return 15% to satisfy debt and equity holders. Fifteen percent is the WACC.

If the only money the bag held was $50 from debtholders, $50 from shareholders, and $100 invested in a project, the return from this project would have to return $5 a year to debtholders and $10 a year to shareholders to meet expectations. This would require a total return of $15 a year, or a 15% WACC.

## WACC: An Investment Tool

Securities analysts employ WACC when valuing and selecting investments. For instance, in discounted cash flow analysis, WACC is used as the discount rate applied to future cash flows for deriving a business's net present value. WACC can be used as a hurdle rate against which to assess ROIC performance. It also plays a key role in economic value added (EVA) calculations.

Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Let's say a company produces a return of 20% and has a WACC of 11%. For every $1 the company invests into capital, the company is creating $0.09 of value. By contrast, if the company's return is less than its WACC, the company is shedding value, indicating that it's an unfavorable investment.

WACC serves as a useful reality check for investors. To be blunt, the average investor probably wouldn't go to the trouble of calculating WACC because it requires a lot of detailed company information. Nonetheless, it helps investors understand the meaning of WACC when they see it in brokerage analysts' reports.

## Calculating WACC

To calculate WAAC, investors need to determine the company's cost of equity and cost of debt.

### Cost of Equity

The cost of equity can be a bit tricky to calculate as share capital carries no "explicit" cost. Unlike debt, equity does not have a concrete price that the company must pay. However, that does not mean that no cost of equity exists.

Common shareholders expect a certain return on their equity investment in a company. The equity holders' required rate of return is oftentimes considered a cost because shareholders will sell their shares if the company does not deliver the expected return. As a result, the share price will drop. The cost of equity is basically what it costs the company to maintain a share price that is satisfactory to investors.

On this basis, the most commonly accepted method for calculating the cost of equity comes from the Nobel Prize-winning capital asset pricing model (CAPM):

$\begin{aligned} &R_e = R_f + \beta(R_m - R_f) \\ &\textbf{where:}\\ &R_e=\text{CAPM}\\ &R_f=\text{Risk-free rate}\\ &\beta=\text{Beta}\\ &R_m = \text{Market rate}\\ \end{aligned}$

But what does that mean?

—*R*_{f}*Risk-free rate**:*This is the amount obtained from investing in securities considered free from credit risk, such as government bonds from developed countries. The interest rate of U.S. Treasury Bills is frequently used as a proxy for the risk-free rate.—*ß**Beta**:*This measures how much a company's share price reacts against the market as a whole. A beta of 1, for instance, indicates that the company moves in line with the market. If the beta is in excess of 1, the share is exaggerating the market's movements; less than 1 means the share is more stable. Occasionally, a company may have a negative beta (e.g., a gold-mining company), which means the share price moves in the opposite direction to the broader market. For public companies, you can find database services that publish betas of companies. Few services do a better job of estimating betas than MSCI Barra. Bloomberg is another valuable source of industry betas.—*(R*_{m}– R_{f})*Equity Market Risk Premium:*The equity market risk premium (EMRP) represents the returns investors expect in exchange for them investing in the stock market over and above the risk-free rate. In other words, it is the difference between the risk-free rate and the market rate. It is a highly contentious figure.

Many argue that it has gone up due to the notion that holding shares has become riskier. The EMRP frequently cited is based on the historical average annual excess return obtained from investing in the stock market above the risk-free rate. The average may either be calculated using an arithmetic mean or a geometric mean. The geometric mean provides an annually compounded rate of excess return and will, in most cases, be lower than the arithmetic mean.

Both methods are popular but the arithmetic average has gained widespread acceptance. Once the cost of equity is calculated, adjustments can be made for risk factors specific to the company, which may increase or decrease its risk profile. Such factors include the size of the company, pending lawsuits, the concentration of the customer base, and dependence on key employees. Adjustments are entirely a matter of investor judgment, and they vary from company to company.

### Cost of Debt

Compared to the cost of equity, cost of debt is fairly straightforward to calculate. The cost of debt (R_{d}) should be the current market rate the company is paying on its debt. If the company is not paying market rates, an appropriate market rate payable by the company should be estimated.

As companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment. Therefore, the after-tax cost of debt is R_{d }(1 - corporate tax rate).

## Capital Structure

The WACC is the weighted average of the cost of equity and the cost of debt based on the proportion of debt and equity in the company's capital structure. The proportion of debt is represented by D/V, a ratio comparing the company's debt to the company's total value. The proportion of equity is represented by E/V, a ratio comparing the company's equity to the company's total value. The WACC is represented by the following formula:

$\begin{aligned}&\text{WACC} = R_e \times \frac{ E }{ V } + \left( R_d \times \frac{ D }{ V } \times ( 1 - \text{CTR} ) \right ) \\&\textbf{where:} \\&R_e = \text{Total cost of equity} \\&E =\text{Market value of total equity} \\&V =\text{Total market value of company's combined} \\&\text{debt and equity} \\&R_d = \text{Total cost of debt} \\&D = \text{Market value of total debt} \\&CTR = \text{Corporate tax rate} \\\end{aligned}$

A company's WACC is a function of the mix between debt and equity and the cost of that debt and equity. On one hand, historically low interest rates have reduced the WACC of companies. On the other hand, the prospect of corporate disasters*—*like Enron and WorldCom in the early 2000s*—*increases the perceived risk of equity investments.

But 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. Even if two people 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.