DCF Analysis - Discount Rates and WACC

Question 1

What does the Cost of Equity mean intuitively?

Answer 1

It tells you the percentage a company’s stock “should” return each year, over the very long term, also factoring in dividends and stock repurchases.

IN a valuation, it represents the percentage an Equity investor might earn each year.

To a company, Cost of Equity represents the cost of funding its operations by issuing shares to new investors.

Question 2

What does WACC mean intuitively?

Answer 2

WACC is similar to Cost of Equity, but it’s the expected annual return percentage if you invest proportionately in all parts of the company’s capital structure - Debt, Equity, Preferred Stock, etc.

To a company, WACC represents the cost of funding its operations by using all its sources of capital.

Investors might invest in a company if their expected IRR exceeds WACC, and a company might decide to fund a new project, acquisition, or expansion if its expected IRR exceeds WACC.

Question 3

How do you calculate Cost of Equity?

Answer 3

Cost of Equity = Risk-free rate + Equity Risk Premium * Levered Beta

Question 4

What does Risk-free rate represent?

Answer 4

What you would earn on “risk-free” government bonds denominated in the same currency as the company’s cash flows. You usually use 10-year or 20-year bonds to match the explicit forecast period of the DCF.

Question 5

What is Levered Beta?

Answer 5

Represents how volatile this stock is relative to the market as a whole, factoring in both its intrinsic risk and the risk from leverage.

Question 6

What is Equity Risk premium?

Answer 6

Represents how much the stock market in the company’s country will return above the “risk-free” government bond.

Question 7

If a company operates in the EU, US, and UK, what should you use for its Risk-Free Rate?

Answer 7

You should use the rate on the government bonds that match the currency of the company’s cash flows.

So if the company reports its financials in USD, you might use the 10-year US Treasury Rate; if it reports them in EUR or GBP, you might use the rate on 10-year notes issued by the Bank of England or the European Central Bank.

Question 8

How do you calculate the Equity Risk Premium?

Answer 8

There is almost no agreement on how to do it because stock-market returns differ based on the period and whether you use an arithmetic mean, a geometric mean, or other approaches.

Question 9

How do you calculate the Equity Risk Premium for a multinational company that operates in many different geographies?

Answer 9

You might take the percentage revenue from each country, multiply it by the ERP in that market, and then add everything up to get a weighted average.

The ERP in each market might be based on anything described above, but the “Historical US stock market returns + default spread” approach is common.

Question 10

What does beta mean intuitively?

Answer 10

Levered Beta tells you how volatile a company’s stock price is relative to the stock market as a whole, factoring in both the intrinsic business risk and the risk from leverage.

If Beta is 1.0, when the stock market goes up 10%, this company’s stock price also goes up by 10%

If Beta is 2.0, when the stock market goes up 10%, this company’s stock price goes up by 20%.

Unlevered Beta excludes the risk from leverage and reflects only the intrinsic business risk, so it’s always less than or equal to Levered Beta.

Question 11

Could Beta ever be negative?

Answer 11

Yes, it’s possible. The company’s stock price has to move in the opposite direction of the market as a whole for Beta to be negative.

Gold is commonly cited as an Asset that has a negative Beta because it often performs better when then the stock market declines.

Question 12

What is the formula for Unlevered Beta?

Answer 12

Levered Beta / (1 + Debt/Equity Ratio * (1 - Tax Rate))

Question 13

What is the formula for Levered Beta?

Answer 13

Unlevered Beta * (1+Debt / Equity Ratio * (1-Tax Rate))

Question 14

How do you calculate WACC, and what makes it tricky?

Answer 14

WACC = Cost of Equity * % Equity + Cost of Debt * (1 - Tax Rate) * % Debt + Cost of Preferred Stock * % Preferred Stock

Its tricky to calculate because there’s ambiguity with many of these items.

Question 15

Should you use the company’s current capital structure or optimal capital structure to calculate WACC?

Answer 15

A company’s “optimal” capital structure is the one that minimizes WACC. But there’s no way to calculate it because you can’t tell in advance how the costs of equity and debt will change as the capital structure changes.

Question 16

Why is Equity more expensive than Debt?

Answer 16

Because it offers higher risk and higher potential returns.

Expected stock market returns exceed the interest rates on Debt in most cases, which already makes the Cost of Equity higher. But interest is also tax-deductible, which further reduces its cast.

Question 17

How does the cost of Preferred Stock compare with the costs of Debt and Equity?

Answer 17

Preferred Stock tends to be more expensive than Debt but less expensive than Equity: It offers higher risk and potential returns than debt, but lower risk and potential returns than equity.

Question 18

How do convertible bonds factor into the WACC calculation?

Answer 18

If the company’s current share price exceeds the conversion price of the bonds, you count the bonds as Equity and factor in by using a higher diluted share count, resulting in a higher Equity Value for the company and a greater Equity weighing in the WACC formula.

Question 19

How does the cost of equity, cost of debt, and WACC change as a company uses more debt?

Answer 19

The cost of equity and debt always increase because more debt increases the risk of bankruptcy, which affects all investors.

As a company goes from no Debt to some Debt, WACC decreases at first because Debt is cheaper than Equity, but it starts increasing at higher levels of Debt as the risk of bankruptcy starts to outweigh the lower cost of debt.

Question 20

Should a company use different Discount Rates for different years in a DCF?

Answer 20

Yes, sometimes

For example, if a company is growing quickly right now, but it’s expected to mature and grow more slowly in the future, you might use decreasing Discount Rates.

Question 21

What should you use for the risk-free rate if government bonds in the country are not risk-free?

Answer 21

Take the Risk Free rate in a country that is assumed to be risk free and then add a default spread based on your countries credit rating.