WACC and Cost of Equity

Every valuation needs a discount rate: the return investors require for the risk of owning a business. For a whole company, the standard choice is the weighted average cost of capital (WACC), which blends what shareholders and lenders expect to earn, weighted by how much of each the company uses. The cost of equity, usually estimated with the capital asset pricing model (CAPM), is the hardest piece. Because the discount rate has a large effect on valuations, understanding how it is built helps traders judge whether a model's output is reasonable.

The WACC formula#

WACC = (E / V) × cost of equity + (D / V) × cost of debt × (1 - tax rate)

• E: market value of equity
• D: market value of debt
• V: E + D

Interest on debt is usually tax deductible, so the cost of debt is reduced by the tax rate.

Cost of equity with CAPM#

cost of equity = risk free rate + beta × equity risk premium

Cost of debt#

The cost of debt is the yield the company would pay on new long term borrowing, estimated from its bond yields or its credit rating plus a spread. See Credit Spreads.

Worked example#

Why the discount rate matters so much#

A higher discount rate lowers the present value of future cash flows, especially those far in the future. Growth companies, whose cash flows are mostly in the distant future, are most sensitive to changes in rates. This is one reason growth stocks fell sharply in 2022 when interest rates rose. See Interest Rates and DCF Valuation.

Beta in practice#

• Raw betas from regressions are noisy and depend on the period and frequency used.
• Adjusted betas (such as Blume's adjustment) move estimates toward 1.0.
• Industry betas from comparable companies can be more reliable, adjusted for each company's debt (unlevered and relevered).

Alternatives and adjustments#

• Implied cost of equity: solve for the return that makes market prices match analysts' cash flow forecasts.
• Build up method: risk free rate + equity premium + size premium + company specific premium, common in private company valuation.
• Multi factor models: use several risk factors instead of beta alone. See Factor Models.
• Country risk premiums for emerging markets.

Common mistakes#

• Using book values instead of market values for weights.
• Mixing currencies: a dollar risk free rate with euro cash flows.
• Using a short term rate as the risk free rate for long term cash flows.
• Double counting risk in both cash flows and the discount rate.
• False precision: WACC is an estimate; test a range.

Frequently asked questions#

What is WACC?#

The weighted average cost of capital: the blended return required by a company's shareholders and lenders, used as the discount rate for its free cash flows.

How is the cost of equity calculated?#

Usually with CAPM: the risk free rate plus beta multiplied by the equity risk premium.

Why does a higher WACC lower valuations?#

Because future cash flows are discounted more heavily, reducing their present value, especially for cash flows far in the future.

Next, learn to value a company against its peers in Comparable Companies and Precedent Transactions.