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).

Understanding WACC

A company's 澳洲幸运5开奖号码历史查询: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 澳洲幸运5开奖号码历史查询:cost of capital is the 澳洲幸运5开奖号码历史查询: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 澳洲幸运5开奖号码历史查询:opportunity cost of ta🐭king on the ri🐼sk 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 澳洲幸运5开奖号码历史查询: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 satis▨fy 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 澳洲幸运5开奖号码历史查询: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 澳洲幸运5开奖号码历史查询:discounted cash flow analysis, WACC is used as the discount rate applied to future 澳洲幸运5开奖号码历史查询:cash flows for deriving a business's 澳洲幸运5开奖号码历史查询:net present value. WACC can be used as a 澳洲幸运5开奖号码历史查询:hurdle rate against which to assess ROIC performance. It also plays a key role in 澳洲幸运5开奖号码历史查询:economic value-added (EVA) calculations.

Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum 澳洲幸运5开奖号码历史查询: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, 澳洲幸运5开奖号码历史查询:if the return is less than its WACC, the company is shedding value, indicating tha♐t 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 澳洲幸运5开奖号码历史查询:cost of equity and 澳洲幸运5开奖号码历史查询:cost of debt.

Cost of Equity

The cost of equity can be a bit tricky to calculate as 澳洲幸运5开奖号码历史查询: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' 澳洲幸运5开奖号码历史查询: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 inv𝔍estors.

On this basis, the most commonly accepted method for calculating the cost of equity comes from the Nobel Prize-winning 澳洲幸运5开奖号码历史查询:capital asset pricing model (CAPM):

$\begin{aligned} &R_e = R_f + \beta(R_m - R_f) \\ &\textbf{where:}\\ &R_e=\text{CAPM}\\ &R_f=\text{Risk-free rate}\\ &\beta=\text{Beta}\\ &R_m = \text{Market rate}\\ \end{aligned}$​Re​=Rf​+β(Rm​−Rf​)where:Re​=CAPMRf​=Risk-free rateβ=BetaRm​=Market rate​

​

But what does that mean?

• R_f —澳洲幸运5开奖号码历史查询:Risk-free rate: This is the amount obtained from investing in securities considered free from 澳洲幸运5开奖号码历史查询:credit risk, such as government bonds from developed countries. The interest rate of 澳洲幸运5开奖号码历史查询:U.S. Treasury Bills is frequently used as a proxy for the risk-free rate.
• ß—澳洲幸运5开奖号码历史查询: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 澳洲幸运5开奖号码历史查询:public companies, you can find database services that publish betas of companies. Few services do a better job of estimating betas than . 澳洲幸运5开奖号码历史查询:Bloomberg is another valuable source of industry betas.
• (R_m – R_f)—澳洲幸运5开奖号码历史查询: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 澳洲幸运5开奖号码历史查询:excess return obtained from investing in the stock market above the risk-free rate. The average may either be calculated using an 澳洲幸运5开奖号码历史查询:arithmetic mean or a 澳洲幸运5开奖号码历史查询:geometric mean. The geometric mean provides a𝓀n annually compounded rate of excess return and will, in most cases, be lower than the arithmetic me🍃an.

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 澳洲幸运5开奖号码历史查询:risk profile. Such factors include the size of the company, pending lawsuits, the concentration of the customer base, and dependence on 澳洲幸运5开奖号码历史查询:key employees. Adjustᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚments are entire𒉰ly 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 澳洲幸运5开奖号码历史查询: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 澳洲幸运5开奖号码历史查询:weighted average of the cost of equity and the cost of debt based on the proportion of debt and equity in the company's 澳洲幸运5开奖号码历史查询:capital structure. The proportion of debt is represented by D/V, a ratio comparing the company's de🍷bt 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:

$\begin{aligned}&\text{WACC} = R_e \times \frac{ E }{ V } + \left( R_d \times \frac{ D }{ V } \times ( 1 - \text{CTR} ) \right ) \\&\textbf{where:} \\&R_e = \text{Total cost of equity} \\&E =\text{Market value of total equity} \\&V =\text{Total market value of company's combined} \\&\text{debt and equity} \\&R_d = \text{Total cost of debt} \\&D = \text{Market value of total debt} \\&CTR = \text{Corporate tax rate} \\\end{aligned}$​WACC=Re​×VE​+(Rd​×VD​×(1−CTR))where:Re​=Total cost of equityE=Market value of total equityV=Total market value𓄧 🌺of company’s combineddebt and equityRd​=Total cost of debtD=Market value of total debtCTR=Corporate tax rate​

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 peꩲrceived risk of equity investments.

But be warned: the 澳洲幸运5开奖号码历史查询: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 tꦉhe same WACC. Even if two people reach the same WACC, all the other applied judgments and v🍰aluation methods will likely ensure that each has a different opinion regarding the components that comprise the company value.