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 over-simplified and 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.
The WACC and CAPM Formulas
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
- w = weights
- d = debt
- e = equity
- r = cost (aka required rate of return)
- t = tax rate
- p = preferred shares
To calculate the cost of equity (re), the standard procedure 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)
- re = cost of equity
- rf = risk-free rate
- β = beta
- rm = expected market return
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.
Flaw #1: 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). 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)
- 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
The value of beta determines the risk-return relationship as shown below:
- Beta > 1.0: Stock offers higher volatility and higher expected returns than the market.
- Beta = 1.0: Stock has the exact same volatility and expected returns of the market.
- Beta < 1.0: Stock offers lower volatility and lower expected returns than the market.
- Beta < 0: Negative beta means the asset correlates negatively to the given market (e.g., with gold stocks/ETFs).
Therefore, if a stock has a beta of 0.97, this means it's almost as volatile as the market (beta of 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.
Flaw #2: Cost of Debt and the Tax Shield
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 number 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 many cases a company that is financed more by debt does not mean 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.
Flaw #3: CAPM and Assumptions
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:
- The stock market is competitive and efficient, and any relevant company information is readily available and quickly absorbed.
- All investors are rational, naturally risk-averse, and hope to maximize satisfaction from investment returns.
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 clearly 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 typically use 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.
Viable Alternatives to the WACC Discount Rate
In seeking alternatives to WACC for stock valuation, we examine Warren Buffett's use of the risk-free rate and the personal required rate of return approach. These methods provide varied options for investors, offering flexibility in aligning discount rates with individual risk profiles and investment goals.
Warren Buffett's Discount Rate Approach
Warren Buffett, a renowned value investor, utilizes the U.S. 10-year Treasury rate as his benchmark discount rate. This rate is considered the risk-free rate because Treasury securities are backed by the full faith and credit of the U.S. government, making them one of the safest investment options available.
However, Buffett adjusts this rate upwards in low-interest environments to account for potential inflation and maintain investment prudence, as mentioned in the quote below:
"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
He also employs a significant margin of safety in his valuation, which compensates for the lower discount rate without adding a specific risk premium. 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 rate, and only adjusts this rate upwards if interest rates are on the low side.
Buffett's approach, while effective for him, presents challenges for individual investors. Adjusting the risk-free rate as he does introduces uncertainty, especially when considering various industries and companies. Additionally, incorporating a large margin of safety, which is crucial at lower discount rates, can be unclear in terms of expected returns. Given that most investors don't have Buffett's market expertise, a more practical strategy might be using a personal required rate of return that aligns with individual knowledge, goals, and risk tolerance.
Personal Required Rate of Return
For individual investors, the personal required rate of return offers a more customized approach. This method centers on each investor's unique expectations and circumstances, including risk tolerance, investment goals, time horizon, and available capital. It involves determining a specific return expectation for each investment, tailored to personal criteria. The rate can vary, with lower rates for stable, mature companies and higher rates for speculative or high-growth investments.
The personal required rate of return is centered around the question: "What is my expected required rate of return from this company each year?" This mirrors the strategy used by Buffett and other value investors when deciding on the annual return they expect from a company's future cash flows
If you're uncertain about the right discount rate, start with a static 10% rate, mirroring the long-term historical average market return. Adjust this rate based on your confidence in estimating the company's future cash flows. Often, aiming for a rate above 10% is sensible, as a low-cost index fund tracking the market typically yields about a 10% return annually, which is typically more predictable than the returns from individual stock picks.
Should this not suffice, the next option is to adopt Buffett's approach of using the U.S. 10-year Treasury rate, applying a substantial margin of safety. Additionally, multifactor models like the Arbitrage Pricing Theory (APT), the Fama-French Multifactor Models, and the Build-Up Method offer a more detailed risk assessment and insight into a company's cost of equity. The Dividend Discount Model (DDM) can also be useful for companies that consistently pay dividends.
The Bottom Line
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.