In this article, I will explain how to calculate and interpret the weighted average cost of capital (WACC), and will walk through a step-by-step example for a real publicly-traded company in the U.S. stock market. The WACC is a calculation of a firm's "cost of capital," which in relation to investors and analysts is the weighted average of a firm's cost of debt and cost of equity. The WACC is also commonly used as the discount rate to determine the present value of a company's future cash flows.
Although the WACC has its limitations as the discount rate and is not very useful to the average investor, it's still a widely accepted figure in finance that can determine the merit of an investment. At the very least, by calculating the WACC, investors can gain a better understanding on how a particular company is financed and its volatility relative to the market. Ultimately, this can be valuable for investors looking to preserve and grow their wealth.
How to Calculate the WACC
As mentioned, the weighted average cost of capital (WACC) is a method of calculating the cost of capital for a company. In other words, investors can calculate the WACC to determine the overall expected return for both equity owners (shareholders) and to debtholders (bondholders).
The WACC includes:
- Cost of debt: The effective interest rate companies pay on their debts.
- Cost of preferred shares: The rate of return required by holders of a company's preferred stock.
- Cost of equity: The compensation demand from the market in exchange for owning the asset and its associated risk.
Below is the complete WACC formula:
WACC = wd * rd (1 - t) + wp * rp + we * re
- w = weights
- d = debt
- e = equity
- r = cost (aka required rate of return)
- t = tax rate
- p = preferred shares
Although the WACC formula can appear complex, it's rather intuitive once you put it into practice. To demonstrate this, we'll find the WACC of Adobe (ADBE), one of the largest and most diversified software companies in the world.
We will begin by finding the cost of equity (re), then the cost of debt portion (wd * rd (1 - t)), and finally the cost of preferred shares (rp). Afterwards, we will apply appropriate weights and calculate the WACC.
Capital Asset Pricing Model (CAPM) for Cost of Equity
To calculate the cost of equity (re), the standard practice is to use the "capital asset pricing model" (CAPM). The CAPM is an investment theory that shows the relationship between the expected return of an investment and market risk.
The CAPM formula is below:
re = rf + β*(rm - rf)
- re = cost of equity
- rf = risk-free rate
- β = beta
- rm = expected market return
Below are the steps on how to find the CAPM for Adobe.
Step 1: Find the Risk-Free Rate (rf)
To find the CAPM (aka cost of equity), begin by finding the risk-free rate (rf), which is simply the rate on the 10-year Treasury Note. This is used because it's the interest rate an investor can expect to earn on an investment with zero risk. As of initial writing, the risk-free rate is 0.94% and is outlined below:
Step 2: Find Beta (β)
Next, find beta (β), which is a measure of systematic risk (aka undiversifiable risk) of a security or portfolio compared to the overall market (aka the S&P 500 Index). By definition, the market has a beta of 1.0. Therefore, betas greater than 1.0 offer higher stock volatility and higher expected returns, while betas lower than 1.0 offer the exact opposite.
For Adobe, you can use a site like Yahoo Finance to find their beta (5-yr monthly) of 0.97. Beta can also be found using the formula below:
Beta = Covariance (re, rm) / Variance (rm)
- re = return on individual stock
- rm = return on overall market
- Covariance = stock's return relative to the overall market
- Variance = how the market moves relative to its mean
See how I found a beta of 0.94 for Adobe on Excel, using 5-yr monthly adjusted close data from Yahoo Finance for Adobe (ADBE) and the market (S&P 500):
Step 3: Find the Expected Return of the Market (rm)
Finally, we can find the expected return of the market (rm). For this, you can use analyst estimates of long-term market returns or the historical average market returns. If we are to choose the historical average market returns, from 1926 to 2018 this has been approximately 10-11%. Therefore, you can use 10% as the expected return of the market.
Solve for Adobe's Cost of Equity:
Putting this altogether gives us Adobe's cost of equity:
re = 0.94% + 0.97*(10% - 0.94%) --> 9.73%
As you can see, the only difference between CAPM for companies in the stock market is their individual beta. All other variables to calculate the cost of equity (CAPM) are the same. Moreover, if Adobe did not issue preferred shares or had no debt, then CAPM would just be equal to the WACC (the discount rate).
A final thing to note here, is that the cost of equity, or what equity investors expect the company to return for them given a level of risk, is typically going to be higher than the cost of debt. This is simply because equity shareholders bear more risk than bondholders, and therefore require a higher rate of return than debtholders.
Cost of Debt
The cost of debt is the interest rate paid on any debt (bonds) issued. Sometimes, this can be found on the footnotes to the financial statements section on a 10-K annual report. If not, you will have to find it yourself.
To estimate the before-tax cost of debt, there are generally three approaches you can take of varying simplicity and accuracy. These three approaches all take into account the tax rate (t) to determine the after-tax cost of debt, which is used in the WACC formula. Therefore, it's important that we know how to find the tax rate first.
How to Determine the Tax Rate
For the tax rate portion (1 - t), where t = tax rate, this only applies to the debt portion, because interest payments on debt are tax deductible, and are therefore favorable.
This tax rate is typically given in the notes to the financial statement (as the effective tax rate), or can be calculated with the formula below:
Tax rate = Income tax expense / Income before tax (EBT)
As shown above, on their most recent 10-K annual report, Adobe has an effective tax rate of 8%. We can then apply this tax rate to the before-tax cost of debt, using one of the methods below:
Method #1: Yield to Maturity (YTM) Approach
The yield to maturity (YTM) is the rate at which the current price of the bond is equal to the present value of all future cash flows from the bond.
Below are the steps to determine the cost of debt with the YTM approach:
- Calculate the YTM of all publicly traded company debt.
- Calculate the weighted average of all debt instruments.
- Multiply the result by (1 - t) to get the cost of debt (rd).
This is the most accurate method to determine the current cost of debt, as bonds change in value on a day-to-day basis, along with the YTM rate, thereby reflecting the cost of debt. Therefore, I will use this cost of debt figure for the WACC calculation.
Here are the bonds Adobe Inc. has currently issued:
In the Excel sheet below, you can see how I found an after-tax cost of debt of 0.8214% for Adobe on Excel, using data from FINRA:
Method #2: Debt Rating Approach (Estimating a Synthetic Rating)
When market prices are not available, you can use a company's credit rating to estimate the cost of debt.
rd = (rf + default spread) * (1 - t)
- rd = cost of debt
- rf = risk-free rate
- t = tax rate
We already know the risk-free rate (rf) from calculating the CAPM, which as a reminder, is just the rate on the 10-year Treasury Note. Again, the risk-free rate (as of initial writing) is 0.94%.
Then, you'd just locate a credit rating default spread table, and calculate the cost of debt. However, if you're unable to find an up-to-date credit rating default spread table, you can opt into estimating a synthetic rating instead, using the interest coverage ratio:
Interest coverage ratio (ICR) = EBIT / Interest expense
See this article on How to Value a Company Using the Discounted Cash Flow Model to see a complete walk-through and default spread table for this particular cost of debt calculation.
In short, here are the steps to determine the cost of debt with the debt rating approach:
- Calculate the interest coverage ratio.
- Estimate the synthetic rating.
- Calculate the cost of debt (rd) using the debt rating approach.
Again, assuming I made no mistakes, you can see how I found an after-tax cost of debt of 1.44% for Adobe on Excel:
Method #3: Interest Expense to Total Debt Approach
The simplest but usually least-accurate approach to determine a company's cost of debt is to use the formula below:
rd = (Interest expense / Total debt) * (1 - t)
- rd = cost of debt
- t = tax rate
- total debt = short + long-term debt
With this approach, Adobe's cost of debt would be 2.27% [(116,000) / 4,708,000) * (1 - 0.08)]. I would only use this method if you want a quick cost of debt figure, or if you are not confident with the first two methods.
Cost of Preferred Stock
The cost of preferred stock is the rate of return required by holders of a company's preferred stock. Preferred stock is a hybrid security that incorporates features from bonds and common stock. It's a special class of equity that typically pays out dividends on a regular schedule, and has priority over common stockholders.
The formula for the cost of preferred stock is below:
rp = Dp / Pp
- rp = cost of preferred stock
- Dp = preferred stock dividend per share
- Pp = current price of each preferred share
Although companies regularly finance themselves and/or projects through common stock and bonds, this is not always the case for preferred stock. In fact, many companies do not issue preferred stock. If your company does not issue any preferred stock, then the cost of preferred stock would just be zero (nonexistent). In this case, you would just use the weighted average required rate of returns for the cost of equity and debt rates found before to calculate the WACC.
To determine whether or not a company has preferred stock outstanding, you can look under the shareholders' equity section of a company's balance sheet. This is shown below for Adobe:
As you can see in the outline, Adobe did not issue any preferred stock, nor has any preferred stock outstanding. Therefore, I would calculate the WACC for Adobe without the cost of preferred stock portion.
However, if the company did have preferred stock outstanding, you can find the cost of preferred stock using the formula above. This information should be available on their 10-K annual report.
Debt and Equity Weights
Now that we know the cost of debt, the cost of equity, and know that Adobe has no preferred stock, the next step is to determine the weights of debt and equity in the WACC formula.
To find this, take the total market capitalization of your company, then determine how much of total debt, common stock, and preferred stock consist of this total figure.
This is shown below for Adobe:
ADBE: Debt and Equity Weights (2020)
As you can see, Adobe is heavily financed by equity, with a we of 97.99% and a wd of 2.01% in 2020. Now, we can use this final piece to finally solve for Adobe's WACC, which is commonly used as the discount rate in discounted cash flow valuations.
Below is the WACC I found for Adobe:
WACC (ADBE) = (2.01% * 0.82%) + (97.99% * 9.73%) --> 9.55%
Adobe has a WACC of 9.55%. This is the minimum amount Adobe needs to return in order for investors to be satisfied. Adobe can also use this figure to determine if they should invest in a project or not. For instance, if Adobe found the same 9.55% WACC figure, they would only consider investing in projects that would return anything higher than 9.55%. Anything lower would be destroying the wealth of the company.
From an investors perspective, the WACC is regularly used as the discount factor (aka hurdle rate) in the discounted cash flow model or similar valuation techniques. In this case, the WACC figure would be used to discount expected future cash flows to what they are worth today, to account for the time value of money.
In general, a higher WACC is a sign of a firm with higher risk, while a lower WACC is a sign of a firm with lower risk. This is because higher WACC's imply that the company is paying more to service any debt or equity they're raising. Therefore, an increase in the WACC denotes a lower firm valuation as well, as investors require additional return for taking on more risk. This can be seen when discounting future cash flows with a higher WACC (discount rate), as the firm will have a lower intrinsic value calculation.
The Bottom Line
In summary, the WACC is calculated by multiplying the cost of each financing source (debt and equity) by its appropriate weight, and then adding the products together to determine the final value. Investors can then use the WACC as a discount rate in valuation models to discount future cash flows, such as in a discounted cash flow (DCF) model or dividend discount model (DDM). After discounting future cash flows with the WACC, this can give investors an idea on the intrinsic/fair value of a company's stock price.
However, as mentioned before, the WACC is flawed as the discount rate for the individual investor, largely due to the simplifications of reality and number of assumptions the WACC contains. Therefore, investors can opt into using the U.S. 10-year Treasury rate for the discount rate, as Warren Buffett does, or can simply use their personal required rate of return instead (such as 10%). Regardless, the WACC is important to understand as it can help investors and analysts determine which investments are the most attractively-priced, while also uncovering companies that are potentially over leveraged with debt.