In this article, I will discuss why the weighted average cost of capital (WACC) is flawed as the discount rate, and what individual investors can use instead to discount future cash flows in a present value calculation. The WACC is a calculation of a firm's "cost of capital," which is the weighted average of a firm's cost of debt and cost of equity. From an investor's perspective, the WACC is commonly used as the discount rate to determine the present value of a company's future cash flows, such as in a discounted cash flow (DCF) model or dividend discount model (DDM). However, as this article explains, the WACC should not be used as the discount rate, largely because it's an overly-simplified assumption-heavy figure that can lead to misleading valuations. Therefore, investors can use their personal required rate of return or even follow Warren Buffett's approach instead to determine an appropriate discount rate.
To understand why the WACC is flawed as the discount rate, we can begin looking at the complete WACC formula:
WACC = wd * rd (1 - t) + wp * rp + we * re
To calculate the cost of equity (re), the standard is to use the "capital asset pricing model" (CAPM). In short, the CAPM is an investment theory that attempts to explain the relationship between the expected return of an investment and market risk. Its formula is below:
re = rf + β*(rm - rf)
If you don't understand how to calculate the WACC, then read this article first: How to Calculate and Interpret the Weighted Average Cost of Capital (WACC). This will help you to understand the rest of this article as well.
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). However, according to the CAPM, beta is the only relevant measure of a stock's risk.
For reference, the beta calculation is shown below:
Beta = Covariance (re, rm) / Variance (rm)
The value of beta determines the risk-return relationship as shown below:
Therefore, if a stock has a beta of 0.97, this means it's almost as volatile as the market (that has a beta = 1.0). So, according to the CAPM, if the market declines 10%, Adobe's stock would drop in value by 9.7%. The problem here is that companies 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 classify a large blue-chip company with solid financials and a higher beta 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). Therefore, from an individual investors perspective, beta is rather worthless.
Another thing to mention here that some investors may assume, 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/annual returns will be higher than a company with a smaller beta.
The cost of debt portion (rd) in the WACC formula is estimated based on the interest rate paid on any debt the company has, which on its own can vary quite significantly depending on the approach used. Regardless, the pre-tax cost of debt figure must be multiplied by the tax shield (1 - t) because interest expense is a tax-deductible item in most countries.
If the weighted average cost of debt and cost of equity are the same, ignoring the cost of preferred shares, debt will always be cheaper than equity due to the tax shield. For this reason, companies with high amounts of debt can sometimes have a relatively low WACC. As you may know, the lower the WACC, the higher the intrinsic/fair value of the company, and the less-risky a stock is implied to be. Therefore, companies with lower WACC's (aka discount rates) will have higher valuations, which can mislead investors into thinking that a particular stock is undervalued, when it may actually be overvalued.
In general, companies with relatively low amounts of debt are able to grow more rapidly and scale their operations over the long-term. Although debt is not a bad thing, as long as it's manageable, in most cases a company that is financed more by debt does not equate to a less risky investment. Therefore, it's fair to say that a company with more debt, implying more risk, should not lead to a higher valuation than an identical company with less debt, as the WACC can sometimes suggest.
The CAPM 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:
Below is a list of most of the CAPM assumptions, what they mean, and why I believe they're unrealistic. Although this is not an extensive list, it covers many of the assumptions the CAPM makes that are arguably 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 standardized models.
However, as individual investors, we should look towards using our own personal required rate of return or an adjusted U.S. 10-year Treasury rate, 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 for the discount rate, or at the very most, a figure that can be used in a separate model.
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 Buffett does as one of the world's greatest value investors. Then, we can use this information to determine the best discount rate approach for individual/retail investors.
Warren Buffett uses the U.S. 10-year Treasury rate (aka risk-free rate) as his discount rate, which over the long-term average has been about 4.37%. However, when interest rates are low, as they've recently been, Buffett adjusts this rate upward by whatever amount seems appropriate. He does this because he thinks the U.S. economy is biased towards inflation. Buffett also has no risk adjustment because he simply doesn't take risks. In other words, he doesn't add a risk premium whatsoever.
“We don’t discount the future cash flows at 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.”— Warren Buffett | 1998 Berkshire Hathaway Annual Meeting
"And once you've estimated future cash inflows and outflows, what interest rate do you use to discount that number back to arrive at a present value? My own feeling is that the long-term government rate is probably the most appropriate figure for most assets. And when Charlie and I felt subjectively that interest rates were on the low side – we'd probably be less inclined to be willing to sign up for that long-term government rate. We might add a point or two just generally."— Warren Buffett | 1993 Letter to the Shareholders
It's important to understand that lower (higher) discount rates lead to higher (lower) valuations. Currently, the risk-free rate is hovering 1-2%, and if you were to apply this to a discounted cash flow (DCF) model to find the intrinsic/fair value price of a company, the company would probably always appear undervalued.
Therefore, to account for these lower discount rates, what Buffett does is apply a huge "margin of safety." Mathematically, this is no different than using a higher discount rate (like 10%), and then applying a smaller margin of safety. However, Buffett doesn't seem to support this point of view and instead uses the risk-free 10-year U.S. Treasury rate, and only adjusts this rate upwards if interest rates are on the low side. Clearly, this has worked for him, and there's nothing inherently wrong with using Buffett's discount rate approach.
However, the problem with Buffett's approach is that it's hard to apply to the individual investor. To begin, even if you were to adjust the risk-free rate upwards as Buffett claims to do, perhaps based on your understanding of the company and/or market, there's still a lot of room for uncertainty here. Moreover, although a large margin of safety is warranted given a lower discount rate, this can be difficult to estimate for different companies and for different industries/sectors. Finally, although you will obviously expect a rate of return higher than the U.S. 10-year Treasury rate, you may not have a solid understanding on the expected rate of return you can expect to receive if you were to apply a big margin of safety. Therefore, because you're most likely not as knowledgeable as Warren Buffet in relation to the overall stock market, the better approach (in my opinion) is to just use your personal required rate of return instead.
When attempting to find the intrinsic/fair value of a company, 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 calculation only becomes more time-consuming depending on how complex the company's capital structure is.
However, as you already know, this is the wrong approach to take, not only because the WACC is flawed as the discount rate, but also because Warren Buffett 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 Buffett 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 a particular 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 reasons. Regardless, there is still a general approach investors can follow to determine their personal required rate of return.
To determine my personal required rate of return (as a young investor with a long time horizon), 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 mature (slow growth) 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 10-20% for KO, to determine the price I would pay to purchase the stock.
On the other hand, if I were looking to purchase a less mature (high growth) 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're uncertain on what discount rate to use, use a static 10% discount rate, which is the long-term historical market average annual return. However, if you use a static discount rate of 10%, keep in mind that you must 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 flow growth) than from a defensive low-growth energy company (with potentially relatively consistent cash flow growth).
Finally, if all else fails, the next-best choice is to use the U.S. 10-year Treasury rate as Buffett does and apply a huge margin of safety. If you're not comfortable with this, then you can use the WACC as the discount rate, which you can also use to compare to your personal required rate of return for the company. Although not discussed, investors can also calculate the Arbitrage Pricing Theory (APT) and/or the Fama and French Three Factor Model as well to estimate the cost of capital (discount rate), although these can be harder to implement and estimate.
In summary, the WACC is a calculation of a firm's cost of capital, and is often used as the discount rate in present value calculations to account for the time value of money. Traditionally, after applying the WACC as the discount rate, investors will receive an intrinsic/fair value figure for a particular company. Theoretically, this can give investors an idea on whether the current stock price is overvalued or undervalued.
Unfortunately, the WACC is flawed as the discount rate because it carries far too many false assumptions, relies on beta as a form of risk, and can be misleading due to the tax shield on the cost of debt. Individual/retail investors should therefore avoid using the WACC as their discount rate for valuation purposes.
Instead, investors can use a discount rate of about 10%, the annual average return of the market, and then adjust this rate slightly depending on how confident they are in estimating the company's future cash flows. Afterwards, investors can apply an appropriate margin of safety and perform a sensitivity/scenario analysis to account for any errors, uncertainties, and/or assumptions in the fair/intrinsic value calculation. Although this can be more difficult to apply, investors can also use the U.S. 10-year Treasury rate (risk-free rate) as the discount rate (like Warren Buffett), and apply a huge margin of safety afterwards.
Therefore, the takeaway here is to determine your personal required rate of return, and to then apply this as the discount rate in your present value calculations. If a company's intrinsic/fair value calculation appears undervalued after performing a sensitivity/scenario analysis and applying an appropriate margin of safety, then you can be fairly confident that you will make a return on your investment equal to or even greater than your personal required rate of return. Ultimately, this can minimize your downside risk and lead to long-term investment returns.