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Why the WACC Is Flawed as the Discount Rate

Fajasy
Updated: January 14, 2021
Reading Time: 15 minutes

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In this article, I will explain the Weighted Average Cost of Capital (WACC) and walk through an example on how to calculate the WACC with a real company in the stock market. Afterwards, I will discuss why the WACC is flawed as the discount rate, and what individual investors can use instead to discount their present value calculations. In the end, this information should enable you to build better models and value companies more accurately.

How to Calculate the Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is a method of calculating the cost of capital for a company. In other words, we find the WACC to determine the overall expected return for both equity owners (shareholders) and to debtholders (bondholders).

WACC accounts for:

  • Cost of debt: The effective interest rate companies pay on their debts.
  • Cost of preferred shares (if any): The rate of return required by holders of a company's preferred stock.
  • Cost of equity: Compensation market demands 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

where:

  • w = weights
  • d = debt
  • e = equity
  • r = cost (aka required 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) to Find the Cost of Equity

Now, for the cost of equity (re), the standard 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)

where:

  • 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. Currently, 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. By definition, the market has a beta = 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)

where:

  • 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.

Solving 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:

  1. Calculate the YTM of all publicly traded company debt.
  2. Calculate the weighted average of all debt instruments.
  3. 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:

Assuming I made no mistakes, 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)

where:

  • 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 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:

  1. Calculate the interest coverage ratio.
  2. Estimate the synthetic rating.
  3. 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 and least accurate approach to determine a company's cost of debt is to use the formula below:

rd = (Interest expense / Total debt) * (1 - t)

where:

  • 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

where:

  • 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:

adobeweights 1
Debt and Equity Weights (2020) - ADBE

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.

Adobe's WACC

Below is the WACC I found for Adobe:

WACC (ADBE) = (2.01% * 0.82%) + (97.99% * 9.73%) --> 9.55%

Therefore, 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.


See my article on How to Value a Company Using the Discounted Cash Flow Model to see a real-world example on how the WACC is applied to determine a stock's intrinsic value.

Why the WACC is Flawed as the Discount Rate

Now that you're familiar with the Weighted Average Cost of Capital (WACC) and what purpose the figure serves, both for companies and investors, I will now discuss why the WACC is flawed, and why I believe investors should avoid using the WACC as their discount rate for valuation purposes.

To recap, the WACC, from an investor's perspective, is commonly used as the discount rate to determine the present value of a company's cash flows, such as in a DCF model or dividend discount model (DDM). This will provide investors an intrinsic value buy-price range for the business, and will give investors an idea on whether the current stock price is overvalued or undervalued.

Typically, the higher a company's cost of capital (WACC), the lower its fair/intrinsic value calculation will be. The problem with the WACC, however, is that any slight change to this WACC figure can significantly alter whether a company is undervalued or not, even if it's only by 1%. Often times, any two investors/analysts will rarely come up with the same value for the WACC, due to the assumptions and methods used to reach the end result figure.

This, along with the variables, uncertainties, and assumptions the WACC includes, makes the figure flawed to use as the discount rate.

Beta and Risk

Beta (β) is a measure of volatility, not risk. It's not a measure of total risk, but of market-fluctuation related risk. In other words, beta tells you how much a stock price moves relative to the overall market (aka S&P 500). According to the CAPM, beta is the only relevant measure of a stock's risk.

The value of beta determines the risk-return relationship as shown below:

  • Beta < -1.0: Stock price is more volatile than the market and moves in the opposite direction of the market.
  • -1.0 < Beta < 0: Stock price is less volatile than the market and moves in the opposite direction of the market.
  • Beta = 1.0: Risk and return are in balance and stock price has the same volatility as the market.
  • 0 < Beta < 1.0: Stock price is less volatile than the market and moves in the same direction of the market.
  • Beta > 1.0: Stock price is more volatile than the market and moves in the same direction of the market.

From our example, Adobe has a beta of 0.97, meaning it's almost as volatile as the market (that has a beta = 1.0). Therefore, according to the CAPM, if the market declines 10%, Adobe's stock would drop in value by 9.7%.

The problem here is that company's with a beta over 1.0 are implied to be more risky, and company's with a beta below 1.0 are implied to be less risky. However, this is flawed because past or current stock price volatility does not equal risk!

In most cases, it's absurd to assume that a large blue-chip company with solid financials and a higher beta (more volatility) to be classified as riskier than a smaller, perhaps slow-growth company, that is barely making a profit but happens to have a smaller beta with less stock price volatility.

Another thing to mention here is that a company's average return is not positively related to the CAPM beta. So, if a company has a relatively high beta, this does not mean that it's average monthly returns will be higher than a company with a smaller beta.

CAPM and Assumptions

The Capital Asset Pricing Model (CAPM), as you may know, is used to determine the cost of equity in the WACC. The problem with the CAPM, and one of the main reasons why it makes the WACC misleading as the discount rate in present value calculations, is due to the number of false assumptions it has.

To begin, the CAPM builds on the two main assumptions of modern financial theory:

  1. The stock market is competitive and efficient, and any relevant company information is readily available and quickly absorbed.
  2. All investors are rational, naturally risk-averse, and hope to maximize satisfaction from investment returns.

Below is a list of the CAPM assumptions, what they mean, and why I believe they are unrealistic. This is not an extensive list, but it covers many of the assumptions CAPM makes that are obviously false:

As you can see, the CAPM is quite unrealistic and easy to criticize. Regardless, it's still used in the finance world as the simplification of reality it provides is often needed to build useful models.

However, as individual investors, we should look towards using our own personal required rate of return, as later discussed. It does not make sense to tolerate CAPM's assumptions and its uncertainties, when we could instead use a figure that better applies to our risk tolerance and investment goals. The WACC should therefore only be seen as the next-best choice, or at the very most, a figure that can be used in a separate model.

What to Use Instead of the WACC

Now that we understand why the WACC is flawed as the discount rate, what discount rate should we use instead? To begin, we can look at what Warren Buffet does, who is one of the world's greatest value investors. Then, we can use this information to determine the "best" approach for individual investors.

What Warren Buffet Does

Warren Buffet has commented that he uses the treasury rate (aka risk-free rate) as his discount rate, which over the long-term average has been 4.39%. However, when interest rates are low, as they've recently been, Buffet adjusts this rate upward by whatever amount seems appropriate. He does this because he thinks the U.S. economy is biased towards inflation. Buffet also has no risk adjustment because he simply doesn't take risks. In other words, no risk premium is added whatsoever.

The problem with Buffet's approach, is that it's hard to apply to the individual investor. To begin, a discount rate of below 5% would provide you with a very high valuation on a company. Currently, the risk-free rate is hovering 1%, and if you were to apply this to a DCF model to find the intrinsic/fair value price of a company, the company would probably always appear undervalued. Even if you were to adjust this rate upwards as Buffet sometimes does, perhaps based on your understanding of the company, there's still a lot of room for error and uncertainty here.

Therefore, using the treasury rate and/or adjusting this rate upwards depending on the market is rather vague and not a good approach for individual investors to take. After all, when was the last time you found a company that was so cheap that you could apply a discount rate below 5% and feel confident in your fair/intrinsic value buy price?

What Investors Should Do

When valuing companies, the mistake many investors make with the discount rate, is to immediately think: "What is their cost of capital (WACC)?" This is then followed by them spending a lot of time on trying to estimate the most accurate cost of capital figure to use as their discount rate, as they're aware of how much a small change in the discount rate can completely change a company's fair/intrinsic value. This only becomes more time-consuming depending on how complex the company's capital structure is.

However, this is the wrong approach to take, not only because the WACC is flawed as the discount rate, but also because Warren Buffet and many other value investors do not follow this approach. Instead, investor's should ask: "What is my expected required rate of return from this company each year?" This, more or less, is also what Buffet does when he decides to purchase a company at a particular price.

Stated differently, the discount rate should be your personal required rate of return, which is the return you want the company to generate on their cash flows on an annual basis. This will differ from person to person, because of the differences in risk-tolerance, investment goals, time horizon, available capital, and even where we live, among other things. Regardless, there is still a general approach investors can follow to determine their personal required rate of return.

How I Determine My Personal Required Rate of Return

For reference, I'm a young investor with a higher risk tolerance and a longer investment time horizon. To determine my personal required rate of return, I use multiple tiers of discount rates, and then apply another margin of safety after this depending on the investment. Granted, these figures will vary slightly depending on the company, what industry it's in, the current state of the market, and the growth expectations I have for the company.

For instance, if I'm very confident that my forecast cash growth is conservative and more than likely to happen (i.e. in a DCF or DDM), I will use a lower discount rate as low as 8-10%. Typically, this would apply to slower growth mature companies like The Coca-Cola Company (KO). Personally, if I can get between 8-10% annually from my investment in KO, this would be great. Then, I'd apply a smaller margin of safety to my DCF or DDM because I'm confident in my valuation, somewhere between 10-15%, to determine the price I would pay to purchase the stock.

On the other hand, if I was looking to purchase a high-growth, less mature technology company where future cash flows are less certain/predictable, such as Slack (WORK), then I'd use a discount rate of about 12-14%. For stocks that I deem even riskier/speculative, I'd go as high up to 20%. Most likely, I'd also apply a larger margin of safety (i.e. above 20%) as I'd be less confident in predicting the company's future cash flows.

If you are uncertain on what discount rate to use, use a static 10% discount rate, which is about the market average annual return. If you are to use a static discount rate of 10%, keep in mind that you will have to adjust your margin of safety appropriately. Obviously, the big flaw with using a static figure is that you would not expect the same return from a disruptive high-growth technology company (with uncertain cash flows) than from a defensive low-growth energy company.

Finally, if all else fails, the next-best choice is to always use the WACC as the discount rate, or simply to compare to your personal required rate of return for the company. Although not discussed, investors can opt into calculating the Arbitrage Pricing Theory (APT) and/or the Fama and French Three Factor Model to estimate the discount rate as well, although these can be harder to implement and estimate.

At the end of the day, a bargain company will be obvious and will jump out at you, regardless of how simple or complex the model. Therefore, if the future is too uncertain given a company's future cash flows, then as value investors, it's probably just best to wait or move on and invest in another stock that has a higher degree of certainty with its future cash flows.

The Bottom Line

To recap, the WACC is a calculation of a firm's cost of capital, and is often used as the discount rate in present value discounted cash flow (DCF) and dividend discount models (DDMs). However, it's flawed as the discount rate, largely because it carries too many false assumptions and because it relies on beta as a form of risk, when it actually is just a measure of volatility.

Therefore, investors should use a discount rate of about 10%, the annual average return of the market, and then vary this slightly depending on how confident they are in estimating the company's future cash flows. Finally, investors should apply an appropriate margin of safety and perform a sensitivity analysis to account for any errors, uncertainties, and assumptions in the fair/intrinsic value calculation.

Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance investment or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.
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