WACC explained
Вставка
- Опубліковано 18 чер 2024
- Weighted Average Cost of Capital, in short WACC. This seems to be one of the most intimidating concepts in finance. Fear not, this video explains WACC in an easy to understand way. We will cover: what WACC means, how WACC is used, how WACC is calculated in the WACC formula, and why the WACC formula is pseudo-science, in other words: of questionable value and potentially dangerous. What does the acronym WACC stand for? The WACC is the Weighted Average Cost of Capital. Weighted Average indicates that we are going to apply some mathematics to get the proportions right, and Cost of Capital indicates an attempt to identify the cost of various types of capital. WACC is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. The #WACC is often used to try to answer the fundamental question in life for both investors and businesses: can we create value?
⏱️TIMESTAMPS⏱️
00:00 Introduction to WACC
00:30 WACC acronym
00:58 WACC and value creation
01:58 WACC and Free Cash Flow
03:31 WACC and enterprise value
05:06 Analyst stock recommendations
05:42 WACC and NPV
06:39 WACC formula
08:23 Cost of equity in WACC
09:13 WACC and CAPM
10:47 WACC/CAPM limitations
So how does the infamous formula work to calculate WACC? Here’s the simplest version of it, assuming just two classes of capital: debt and equity. Weighted Average Cost of Capital equals the market value of a firm’s debt divided by the market value of debt and equity, times the cost of debt, plus the market value of a firm’s equity divided by the market value of debt and equity, times the cost of equity. Remember the definition of Weighted Average Cost of Capital: a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. So this thing about debt divided by debt plus equity, and equity divided by debt plus equity, takes care of getting the proportions weighted. The multiplication is with cost of debt in the first part, and cost of equity in the second part. Let’s illustrate this with a WACC example of a fictitious company. Debt is $250 million, out of total capital of $1 billion, so 25%. Cost of debt is 4%. Equity is $750 million, out of total capital of $1 billion, so 75%. Cost of equity is 16%. Multiply, and then add up, and you get to a Weighted Average Cost of Capital of 13%. So where does this cost of debt, and cost of equity, come from? The first part is fairly easy to grasp. The cost of debt equals the interest rate that the company pays on its interest-bearing debt, minus the tax benefit of interest expense being deductible. So if the interest rate is 5%, and the corporate tax rate 20%, then the after-tax cost of debt is 4%. Then comes the more challenging part: cost of equity. At this point, I hope you’ll say “what do you mean, cost of equity? Isn’t the whole idea that equity holds no legal obligation for the firm to pay anything?” No, says the economist, you should look at the opportunity cost of the equity capital. An investor doesn’t have to invest in this company if he doesn’t want to, he could earn a return elsewhere. Cost of equity is therefore a required return by shareholders for the risk they take by investing in this specific equity. And that’s where the whole idea goes off the rails, as we start using historical statistics to predict the future, basically fitting a line to past data hoping that this has any semblance to what the future might hold.
Philip de Vroe (The Finance Storyteller) aims to make strategy, #finance and leadership enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: UA-cam videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!
Enjoyed this video? Then please subscribe to the channel, and let's review how WACC fits into Net Present Value calculations: ua-cam.com/video/N-lN5xORIwc/v-deo.html
@Ameer Jack Thanks so much for your reply. I found the site on google and Im waiting for the hacking stuff now.
Looks like it's gonna take quite some time so I will reply here later when my account password hopefully is recovered.
You sir , are a blessing to us finance and accounting students. Thank you so much
It's my pleasure!
Taking Financial Management and Accounting for Decision Makers for my MBA and this channel is god-send. Appreciate your help kind sir, these concepts are so easy to understand now thanks to you. The NPV for subscribing to this channel was positive ;)
Hahaha! I am so happy to hear that. Please spread the word to your fellow MBA students!
Any chances you might be studying at la trobe because those r the subjects for my mba too 😂
tysm, ive been looking forever for a video that explains it well. this one really knocks it of the park.
Wow! Thank you. Here's the link to a playlist with related videos (WACC vs IRR, WACC vs hurdle rate, etc.) that you might like: ua-cam.com/video/ZuH_q5crAWg/v-deo.html Please subscribe, and share the video!
While reading for the second time “wealth of nations” something related to NPV brought me to your channel and across this video….you sir are outstanding!
Thank you so much for this channel.
Please don’t stop spreading knowledge, on my side I will spread your channel.
Thank you very much for the kind words, Esteban! We have a deal. 😉
P.S. Feel free to send me a Linked In invitation. I tried to find you there, but there are too many Esteban Romeros to be sure...
Thank you so much. My textbook and teacher weren't able to teach me anything this way. Nearly failed my midterm but with this I think I'll ace my final. 😁
Great to hear that, Paulina! Happy to help. Here's my playlist with all related capital budgeting terms: NPV, IRR, crossover rate, profitability index, etc. ua-cam.com/video/N-lN5xORIwc/v-deo.html
I subscribed because I have understood all of these terms and how you're arriving at the solutions. Well done.
Wonderful to hear that, Tom! Thank you for watching and subscribing, please spread the word!
Yet another outstanding video, which even I can understand. I can see myself ditching my MBA tutor's reading list for your videos.
Well done, Ian! I like your plan. By the way, are you in any way related to guitarist Bernie Marsden?
Wow. You have the entirety of principles of finance uploaded to here. Have you considered writing a textbook?
Thank you, Trey! I did think about writing a book for a moment, but decided I prefer the video format, always linking to the most recent examples and numbers I can find, as well as picking only those topics that I find useful and interesting. You should consider a membership to the channel, I plan to start doing live webinars with channel members soon!
I love how you explain the concepts and the examples you bring into the videos. Maybe you could consider making a course :)
Thanks for the kind words! Happy to help. I have bundled related videos into playlists that kind of act like courses. For example, this video on WACC fits very well into the NPV IRR WACC playlist, where I cover many related topics and provide additional examples: ua-cam.com/video/ZuH_q5crAWg/v-deo.html&pp=gAQBiAQB Have a look! My Accounting 101 playlist is also quite popular. And please spread the word to friends and colleagues. 😊
Better and clearer explanations than given me by my really good Corporate Finance professor at Business School!
Wow, thanks for the compliment, Audrey! Send him/her my regards. ;-) Please subscribe, and please tell your fellow students about the channel.
Perfectly clarified. Had to rewind a few times for clear understanding (it doesn't cross my path everyday) but yeah....'floods' happen so outcome could potentially be arbitrary.
Thanks Michel! Yes, I agree that's a lot of information in one video. ;-) Currently working on a follow-up video on WACC versus hurdle rate. Coming soon!
Woah ! You indeed are a master of storytelling ! This makes learning financial concepts so interesting !
Thank you! :-) I think it is important to point out what a financial concept is trying to achieve, and what are its limitations. I have done similar things for financial ratios such as the current ratio (balance sheet analysis) ua-cam.com/video/dkiSWO2OYho/v-deo.html and the interest coverage ratio ua-cam.com/video/P19tw3Hb7TA/v-deo.html They seem easy and straightforward, but there is more to it when you dig in deeper....
Man calls WACC whack and the world proves his point immediately after.
Yep, valuations can be mostly driven by emotions.
HOPE ALL is WELL? Love your videos thank you for sharing and teaching us your knowledge. I was wondering if you can demonstrate this explanation with a company in the stock market. I have better sense when i see examples like that. Watching your NPV and IRR videos which i clearly understand led me to here to the WACC video as my curiosity struck again LOL. Thank You!
LOL! Yeah, that's my goal: trying to lead you from one video to the other, so you see the connection between the concepts. In the WACC video, there is a stock market valuation example at 03:31 in the video. If I would use NPV and WACC myself for valuation of stocks, I would certainly share that in a video, but I don't use these concepts in real life. I think the events of this year 2020 (as well as crises in the past) have conclusively proven that doing a valuation based on extrapolation and stable circumstances is fairly useless. Instead, I make my stock market decisions based on other approaches (like searching for "convex optionality"). See my video on how to invest in the stock market: ua-cam.com/video/K4mWd2zBYVk/v-deo.html and my video that shows what I actually have in my portfolio: ua-cam.com/video/GBLNKbOgQ4w/v-deo.html and how my returns are really driven by just 2 stocks that performed spectacularly.
@@TheFinanceStoryteller Thanks for replying to me I highly appreciated..I would definitely watch those videos. Im a very horrible at explaining things. What i meant to Say is i wanted to know where would you pull those numbers from a stock or a real life situation from the Variables of the formula and where would you place them to what part of the Equation/Formula, So i could have a better understand of the Term/Variable and formula and to use a stock valuation.LOL hopefully that make sense... "Well back to digging for more Info, as "Learning is a Never Ending Story".Keep them videos coming
There are websites that give you estimates of WACC by company. For the Free Cash Flow (FCF) part of the forecast, you could start with the latest reported actual numbers for a year (either directly from the annual report, or calculate FCF from the cash flow statement) and then make your forecasts of future FCF by making assumptions about the company's industry, its revenue growth, its margin performance, its CapEx, etc.
The video is all over the place but great insight if you understand/ have small knowledge prior. Good video
Glad it was helpful! I think you will enjoy the related video on WACC vs hurdle rate as well: ua-cam.com/video/8EyFLdOTuHU/v-deo.html
Your explanations are clear and concise, but this one went way over my head haha
Hi Collin! Yeah, this is one of the tougher concepts. It might take a while to sink in. Maybe watching the related video on WACC vs hurdle rate will help (I think that one is a bit more intuitive) ua-cam.com/video/8EyFLdOTuHU/v-deo.html
or WACC vs IRR ua-cam.com/video/ZuH_q5crAWg/v-deo.html
Hi man,
I love you, God bless you.
You are the best finance teacher I have ever seen.
Looking forward to see more content
Have a good week :-)
Wow, thanks, Yassine!!! Your comments provide excellent motivation for the new week. 😎
Speaking of adding more content.... Did you come across any topics in your studies that I haven't covered on my channel?
I love that you were highlighting the probability and likelihood of unexpected catastrophic market events being materially higher than is priced in… and then boom… COVID begins one month after you uploaded. 👍
Yep... WACC works only in a mild variation environment where normal distributions and standard deviations apply. The real world is full of wild variation situations: powerlaws and fat tails.
@@TheFinanceStoryteller I'd like to get your opinion here... do you think that means that WACC output should be lower driven by a lower cost of equity? Investors expect higher returns thinking there is less risk in the world... until the pendulum swings the other way and fear results in investors settling with lower returns and capital preservation. Wouldn't this mean that if you're using a cost of equity of, say, 15%... it might actually prove to be more like 7%? I presume that it would depend on the stock too. Some more speculative names may have a cost of equity of 15% that should be 30% given how speculative the future cash flows are.
I would proceed to apply the WACC formula as intended, but put the outcome of the calculation in perspective and not attach a disproportional value to it. What I am trying to say is: whatever comes out of a WACC calculation, is not to be treated as the one and only answer. Look at convexity vs concavity of a company, fragility vs robustness vs antifragility. Use the WACC calculation (for valuation) as a datapoint, to be treated with caution.
Thanks for the extremely helpful video and clear explanations. Thanx Thanx Thanx
You are welcome! Glad it was helpful. Please subscribe to the channel, and have a look at the related videos in the playlist: ua-cam.com/video/ZuH_q5crAWg/v-deo.html
Very well explained - thank you.
Glad it was helpful, Mark! 😎 As you noticed, I like to point out the limitations of these concepts as well.
Thank you so much. You make Math so simple unlike my teacher. Please do a sink fund example. thanks.
Happy to help, David! Please share the video with fellow students.
Two suggestions for related videos to watch:
WACC vs hurdle rate ua-cam.com/video/8EyFLdOTuHU/v-deo.html
Discounted Cash Flow (DCF) ua-cam.com/video/Wez6_1-9WiU/v-deo.html
I had not heard of the term sink fund before, let me look into it and see if this is something that I want to make a video on.
This channel was invaluable during my MBA. You’re a fantastic educator. Thanks for your work.
Considering that WACC and DCF analysis involves assumptions that can be quite unreliable, do you think it’s still a useful model despite its flaws? Do you think behavioral economics or alternative models more accurately predict returns?
Thanks for the kind words, Evan! Please share the link to the channel with new generations of MBA students.
DCF analysis is nice as a thought experiment, and for entertainment purposes. There can be quite a bit of confirmation bias in the assumptions, and obviously you cannot forecast or predict the "unknown unknowns". Yet, those unknown unknowns are the ones that can have a huge impact on future share prices.
The problem I see with behavioral economics is that it is not easy to generalize their findings to a bigger environment, and that it focuses on trivial matters not the "life or death" category of problems. In general, I have turned away over time from prediction, and am far more interested in Nassim Taleb's work operationalizing concepts like convex vs concave, and building robustness (instead of fragility) or even better antifragility (benefiting from disruption).
@@TheFinanceStoryteller I’m also a fan of Taleb’s work. Do you have any content about implementing his principles in an individual portfolio? Lately I’ve been looking into barbell portfolios and tail hedges, but it seems like many of Taleb’s strategies would require the resources of a large fund to take advantage of.
I enjoyed this very much. Thank you!
Great to hear that, Matthew!!! I made a follow-up video WACC vs hurdle rate that can also help put things in perspective: ua-cam.com/video/8EyFLdOTuHU/v-deo.html
@@TheFinanceStoryteller Thanks for the recommendation! I'll check it out.
Really good and understandable ! Thank you to "The Finance Storyteller"
De rien! :-)
Can you explain about forecasting future FCF annually? I think you didn't explain about that here.You explained about WACC and DCF but I couldn't understand about forecasting future FCF annually.
Hello Kirthik! Forecasting future Free Cash Flow is mostly a matter of extrapolating trends from the past by using expectations about the future. Take a look at my Netflix Free Cash Flow case study to understand more: ua-cam.com/video/ikizI8dX1SA/v-deo.html Sadly, this kind of extrapolation only works under (very) stable conditions. Disruptive shocks like we have this year throw off any Free Cash Flow forecast that anybody may have made at the start of the year, and hence they make the basis for any spreadsheet-based valuation very shaky.
very great video as usual, I do have one question. I understand WACC but sometimes WACC is used to work out the multiple when using the CCF approach (for example) in valuation. To get this multiple, you take the WACC deduct the expected growth rate you arrive at a Cap rate and then you take 1/cap rate to get the multiple. My question is why is the growth rate deducted?
When dong the DCF method the terminal year carries the growth rate, so I get this the DCF method of valuation why you would deduct the growth rate from the WACC (double counting?) but when doing the CCF method which uses historical data and therefore the expected growth of the company isnt captured anywhere why would you still use a multiple which has the growth rate deducted instead of just taking 1/WACC and using that multiple?
I know this is a bit beyond the scope of your video but as you are so good at explaining and this is in the realm of your topics as an "intermediate" student (Or so I believe i am at least lol) could you help me one step further understand the relationship between the WACC and the deduction of the growth rate in arrived at the multiple actually used in the valuation you were speaking about above? This part I am unclear of. Thank you.
Hi Lisa! I think you are winning the prize for most complicated question on this channel so far. 😉 What you are describing did ring a bell, so I browsed through my 1991 (ha!) edition of Brealey and Myers' "Principles of corporate finance" to look for a discussion of the topic. It is full of statements and assumptions that, after reading Nassim Taleb's "The Black Swan" (please read it!), appear very farfetched, circular, subjective and naïve to me. Brealey and Myers seem to be working off hypotheses like "share price equals the present value of level stream of earnings plus present value of growth opportunities", and "price equals the present value of expected future dividends". I don't think they directly include WACC in the conversation here. They define market capitalization rate with the formula r = (DIV1 + P1 - P0) / P0, in other words expected return for a shareholder is equal to the expected dividend plus expected share price appreciation (i.e. the difference between P1 and P0), divided by the price at the start of the year P0. If you expect $5 dividend and $10 share price appreciation on a stock that is currently trading at $100, then your r = 15%. They then go on to assume a constant growth rate for a company's dividends, and suppose that you could also calculate r as DIV1/P0 + g, in other words dividend yield plus expected growth rate in dividends. So if we established previously that r = 15% and DIV1/P0 is 5%, then as a result g must be 10%. That formula of r = DIV1/P0 + g can be rewritten as P0 = DIV1 / (r-g), by doing the math trick of moving things around in a formula with a numerator and denominator. $5 / (.15 - .1) = $100. Share price is now the "outcome variable" instead of an input variable. You can only use this rewritten formula when r is greater than g. Here's where I think I get close to answering your question: as g approaches r, the stock price becomes infinite.
I kind of enjoy the mathematical aspects of it, but believe that the concepts above are fairly useless in a world that is not linear, stable and predictable. You can learn them just to pass a test, but I would forget about them immediately thereafter. Instead, it's VUCA everywhere! 😉 ua-cam.com/video/KleIttf1xA4/v-deo.html
Let me know if I am making any sense!
@@TheFinanceStoryteller wow you are the absolute best youtuber (and I follow tons of channels!). I truly appreciate you replying, you really have a passion for this stuff and lol @winning the prize for most difficult question so far, that made me laugh out loud. I actually have an exam tomorrow - final professional exams (yikes) and I will read up and review your comments in even more detail tomorrow after the exam, but I couldn't wait to tell you how awesome you are... looking forward to watching all your videos and hopefully having some good intellectual discourse on the topics.
Thanks for the kind words, Lisa! Please spread the word. Wishing you lots of success in your exam! Let me know how it went. It's great that you watch a lot of videos and ask a lot of questions, in addition to studying the "regular" textbook material. That will get you very far!
I don't get it at all.
Sorry to hear that! Maybe try the "hurdle rate vs WACC" video first, it provides some context on how discount rate relates to risk profile: ua-cam.com/video/8EyFLdOTuHU/v-deo.html&pp=gAQBiAQB
Very well explained!
Glad it was helpful!
Thanks for this!
My pleasure!
Outstanding!
Thank you kindly, Bruno!
thank you!
You're welcome! Happy to help.
Awesome videos, do you have one for crossover rate?
Not yet! Thank you for the suggestion, Rithic. Let me evaluate whether I can make a video on that.
Done! Here's the link to my new video on crossover rate and NPV profiles: ua-cam.com/video/PFntbB_9I1U/v-deo.html
@@TheFinanceStoryteller amazing! thank you
Very useful video!
Thank you! Great to hear that. I have made a follow-up video discussing WACC vs hurdle rate: ua-cam.com/video/8EyFLdOTuHU/v-deo.html
I had to keep going back when you got to enterprise value. I thought this video was about calculating WACC, but then I see you applying NPV formula and and going into calculating fairvalue..lol I understood kinda, but I just felt like you jumped ahead a bit so it took a few watches
Thanks for the feedback! Yes, the videos is as much about what people use WACC for as it is about WACC itself.
@@TheFinanceStoryteller Hello. How do you suggest to master finance problems. I usually understand the basics, but when time to do the problems I get stuck.
@@kaozzzzzzzzz1 Read the problems very carefully, and answer the specific question that is being asked. Don't "overthink" the way the problem is phrased. And practice a lot!
Amazing !!keep going 👌👌
Thank you!!!! :-)
Excellent episode
Thank you! Please check out the video on the more intuitive concept of hurdle rate as well: ua-cam.com/video/8EyFLdOTuHU/v-deo.html
you sir should start a playlist teaching for CFA
Thanks! If only I had a clue what the CFA curriculum includes. ;-)
Excellent teaching
Thanks and welcome! More related concepts in this playlist: ua-cam.com/video/N-lN5xORIwc/v-deo.html
What I'm wondering is, is it better to use the WACC in a stock's DFCF analysis for the discount rate, or the rate that you'd like to earn?
For example, I've been eyeing Walmart stock since the beginning of the year.
Today, Walmart's stock is at $138.10 per share.
I calculated Walmart's fair value price to be about $157 per share, with a WACC of 4.9% as a discount rate.
So, I assume that if I buy this stock at $157, then I could expect to earn at most 4.9% in the long run?
Or, should I use a discount rate of 10%, which puts the fair value price at $35.20?
This way, if I buy the stock at $35.20 (which I don't think it's going to get that low any time soon!), I could expect to earn 10%?
Or...is there something I'm missing here?
Hi Richard! Very good question. What you are trying to achieve is to translate the estimates of future free cash flows into today's equivalent. For companies with a "risky profile", you use a higher discount rate. For companies that you expect to be quite stable and predictable, in other words you have a higher feeling of certainty, you use a lower discount rate. A WACC of 4.9% for Walmart sounds reasonable. For a startup that has not commercialized its product yet and operates in an environment with a lot of competition, 10% or 15% might be more appropriate. See also my video on WACC vs hurdle rate: ua-cam.com/video/8EyFLdOTuHU/v-deo.html You could also play around with the rate (scenario analysis), and figure out at which discount rate the outcome of your DCF calculation equals the current share price. In doing that, you have implicitly calculated what WACC the market seems to be using for Walmart (assuming people have the same estimate of the undiscounted future cash flows). To zoom out to the bigger picture, take a look at my time value of money video ua-cam.com/video/gkp-7yhfreg/v-deo.html
@@TheFinanceStoryteller Okay, thanks for the clarity on the matter! :-)
Thank you for the video, I have a question: how can I calculate the equity ratio to determine the WACC in the following example?
Share capital: 100
Profit carried forward: -200
Debt capital: 300
Can I also determine a WACC with this financing structure that I can use for discounting or is this not possible with negative equity?
Hello Jan! Agree with you that the WACC formula will not work with negative equity values. You could try "market value of equity" (assuming this is a company publicly traded) instead of book value, or use the rule of thumb ranges that practicioners use ua-cam.com/video/Wez6_1-9WiU/v-deo.html or go for the concept of hurdle rate instead of WACC ua-cam.com/video/8EyFLdOTuHU/v-deo.html
@@TheFinanceStoryteller Thanks for your reply :)
Very good tutorial 👌
Thanks 🙂
Thanks alot
You're welcome! :-)
I think you are the right man to ask this. I kind of understand the concepts of ROIC and WACC now, but I’m trying to wrap my head around the fact if the magnitude of the WACC and/or the spread between ROIC and WACC is of any importance in judging the quality of the company and the ability of it to create value?
In a way, I would assume that the WACC is mostly the same for most companies. The interest rates don’t differ much on a certain point in time. And the cost of equity would come down to maybe only the risk free rate as the risk premium is useless as you describe in the video.
All quality aspects between companies being equal, if the WACC is basically the same for each company or hard to determine as it is pseudoscience, you would pick the one with the highest ROIC right? Without knowing the spread or the magnitude of the WACC, you still have a better chance of exceeding the WACC with the highest ROIC. Correct?
Wouldn’t you just ignore the WACC altogether and just judge a company on the ROIC and other qualities?
Excellent thinking, Michael! What you are talking about is a concept called Economic Value Added (EVA) ua-cam.com/video/LHXOIHQcyOw/v-deo.html which basically looks at the spread between ROIC and WACC. EVA has gained a lot of popularity, I have for example seen it used in bonus plans for senior executives, as well as business portfolio reviews (as in: do we keep this business unit, or sell it).
WACC is often "clouded" in complicated calculations that look sophisticated. A related concept is the hurdle rate, which is more of a heuristic (rule of thumb). Hurdle rate does not pretend to be a number that can be calculated to a level with many decimals, and is much more useful than WACC in thinking about which factors make one company riskier than others: ua-cam.com/video/8EyFLdOTuHU/v-deo.html
Look forward to hearing what you think of those two concepts!
@@TheFinanceStoryteller First of all, thanks for replying so fast and replying at all. It's amazing how you answer all these questions on your videos. Think it's a rarity on UA-cam. So much appreciated!
I heard about EVA and understand its the difference between the ROIC and WACC. The hurdle rate seems to be similar to the WACC + risk premium, but less complicated indeed and maybe more practical.
What I wonder now though after learning all this is if the WACC or EVA impacts the performance of an investment/the stock price? Instinctively you would say the larger the spread the better the business and the better your investment return will be in lets say 10/20 years. But on the other hand, your investment compounds on the ROIC right? And not so much on the spread percentage?
I'm trying to figure out if as a retail investor the WACC and EVA make an impact on your investment return over lets say 10 or 20 years.. Would I have to pay attention to it, or is the ROIC the better indicator of stock performance? I found several studies that say the performance is more correlated with ROIC, and not so much EVA. Not sure if you have an opinion on this but if you do would love to hear it. Nevertheless your videos are worth gold to the investment community!
Hello Michael! Happy to help. I enjoy these conversations. Sometimes even a topic for a new video comes out of it!
I certainly have an opinion on WACC, ROIC and EVA. They are nice tools to look at the past performance of a company, and they would work well to try to predict future performance if the world was a stable place and there were no disruptive events, and no hidden risk. Sadly that isn't the case, and these major disruptive events tend to be the ones that create most of the downside or upside for a stock. Sometimes we have a few years of stability, and the world seems to behave in line with what our models were telling us to expect. And then a new disruptive event hits, and we need to be careful not to "blow up" from the risk in our portfolio.
Let me give you two examples:
1) In the spring of 2021, I bought shares in a European company called Philips, which is active in the medical devices industry. At that point in time, their investor presentation looks great: solid plans for organic growth, lots of ideas for product innovation, attractive acquisitions either done or in the pipeline, margin improvement programs, and free cash flow generation. Anybody that would try to calculate the fair value of the share based on publicly available information at that point in time using WACC, ROI, EVA, P/E ratio, PEG ratio, etc. (I must admit I didn't do those calculations myself for this stock, but did read some analyst reports) would probably have concluded that the share price (around 45 Euro) was lower than the number that came out of any of these calculations (around 60 Euro), hence let's buy shares and benefit from the upside (15 Euro upside potential on the stock, and a healthy dividend payout on top of it). Only a few months later, it turned out the company had a major quality issue with respiratory devices, which they had been hiding, and kept on downplaying. Bad news after bad news after bad news. Sell, sell, sell. Then the executive board decides to give the CEO a big bonus anyway, which makes shareholders furious as they are stock with losses on their shares. More upset investors that sell. Today's share price (early August 2022) is 20 Euro. What did I learn? Beware of hidden risk in conglomerates. I was definitely the sucker investing in Philips based on the available information at the time (even though the company had been through similar turbulent situations in the past where they downplayed huge business issues).
2) Imagine you are interested in 2019 in investing in a company in the travel and leisure industry. You research airlines, hotel companies, cruise companies, etc. For all of the potential candidates, you calculate what you think would be the value per share, based on their forecasts of future revenue, margin, and free cash flow, and using WACC as a discount rate, comparing it to their historical ROIC, etc. Days and days of heavy Excel work. In the end, you decide to go for Royal Caribbean Cruises Ltd (NYSE: RCL) and put all your savings in that stock around Christmas 2019. Then the pandemic hits, travel stops, which is nearly bankrupting this company and many others in its industry. No, you could not have known the pandemic would be coming, but yes, you should have known better and have taken smaller bets with different payoffs. In other words, don't set yourself up to be fragile. Robust is better. Anti-fragile is WAY better.
Hope this helps! Let me know if you have any similar experiences as what I describe above. To me, the best way to learn about the stock market is to be active in it (using small amounts that won't bankrupt me if things go wrong), document my assumptions, test some of the ideas of what could be an attractive stock in real life, and learn from the success stories and failures.
@@TheFinanceStoryteller Thanks a lot again for the extensive answer! I indeed made similar mistakes as well. For example, betting on recommended names that are given in certain blogs or articles like the next best stocks from China or something like that. That is how I started, putting money in companies I didn't understand and betting on themes or certain sectors. I came along way since then and I dare to say that I know better now what to look at, things like free cash flow, interest coverage, ROIC etc.. It's still a hard endeavour but it's a fun one as well. I noticed though that I don't wanna go to deep into stock analysis so the index will do just fine for the most part. But its nice to have some compounders on the side. Again, thanks a lot and keep up this good work! Cheers!
Have a look at my portfolio in here: ua-cam.com/video/GBLNKbOgQ4w/v-deo.html Since making the video, the biotech stock Galapagos in there has dropped significantly, but Synopsys has been doing extremely well. The most important thing is never to "blow up" as an investor, and to do everything to get lucky with some high potential stocks that go 10X.
Great, thank you! So what should we use instead?
Ciao Antonio! Either use a hurdle rate that is sufficiently high and realize that you are analyzing a scenario based on forecasts (i.e. there is never a definitive answer, as the future has yet to happen), or completely move away from forecasting and look at the pay-off space (convexity versus concavity). Regarding hurdle rates, here's my video on that ua-cam.com/video/8EyFLdOTuHU/v-deo.html Regarding convexity/concavity, read the books of Nassim Taleb.
@@TheFinanceStoryteller thank you very much! I'm a big fan of Taleb. Very nice to see your recommendation!
Here's my book review of "Skin in the game": ua-cam.com/video/tQEH9caNMi8/v-deo.html Follow Taleb on Twitter as well, you learn as events unfold....
nice insight!
Glad you liked it! 🙂
OMG THANK YOU VERY MUCH!!!! YOU ARE MY SAVIOUR :)))))
YOU ARE SO WELCOME!!!!! 😎 More good stuff on NPV IRR WACC and related stuff in this playlist: ua-cam.com/video/N-lN5xORIwc/v-deo.html
Brilliant
Thank you, James!
Hi, in the cost of equity formula, why do we deduct the market rate with risk free rate? and why do we multiply the difference with risk free interest rate plus beta? i'm trying to grasp the logic behind cost of equity formula.. 😣 thanks
Hi! I think you were reading it wrong. You take (first part) the risk-free rate + (second part) β times market risk premium. The difference between the risk-free rate and the market risk is the market risk premium.
I love your videos.
Thank you! Please spread the word to friends and colleagues.
Hey, it's me again. Just to make sure, corporate tax rate is decided by the goverment right ? I was going to learn excel today, how do i end up learning finance, LoL. Oh well, i've come this far.
The statutory corporate tax rate is indeed decided by the government. There is a debate among economists whether to use a) the statutory tax rate, or b) the marginal tax rate (which is the same as the statutory tax rate in case a country only has one rate level, but some countries have multiple "brackets"), or c) the effective tax rate (what the company has actually recorded in tax expenses after tax credits etc.) in WACC calculations. The consensus seems to be to go for the marginal tax rate (most conservative and most accurate to calculate with). In case you really want to know how that part works ;-) then I have a video on marginal tax rate ua-cam.com/video/bHGKwQGYlEY/v-deo.html and one on effective tax rate ua-cam.com/video/Ep2kJtzOmmY/v-deo.html But this will take you even further away from learning Excel!
your explaining method is assume bro keep going
Thank you so much 🙂
To find the cost of debt through wacc, will I have to calculate corporate's tax?
Yes, take that data from the income statement (statement of operations) in the annual report. The cost of debt equals the interest rate that the company pays on its interest-bearing debt, minus the tax benefit of interest expense being deductible. So if the interest rate is 5%, and the corporate tax rate 20%, then the after-tax cost of debt is 4%. By the way, the cost of debt is an input into the WACC formula, not an output.
Keep making these..
Will do! I have DCF as a topic to tackle soon.
11:20 this makes more sense now than ever, given that the US is possible of defaulting on its debts
Excellent comment!!! It is a scary thing if it would happen, but certainly imaginable.
One famous example from the 1990s is that the interest rate for the leading Italian telecom company was lower than for the Italian government, as there was a risk of Italy breaking up into Nothern Italy and Southern Italy, and the telecom company was deemed "safer" (lower interest rate) than the government.
@@TheFinanceStoryteller Wow that is such an interesting example! Thank you so much for your videos, they are so easy to understand for someone new in finance like me!
I am happy to hear that!!! Have a look around the channel, there might be more videos that are useful for you. And if you are missing any major topics, let me know.
Beta - volatility shouldn't be part of value calculation because market volatility has nothing to do with value of a company.
Why do we accept the project if the lrr >cost of capital
If the cost of capital at 20% npv is positive
If the IRR is greater than 20% npv is zero
Then why are we choosing irr which is lowering npv /0 amount
Higher the discount rate lower the npv is it?
I think you are a bit confused on how these concepts relate to each other. Have a look at my video on IRR ua-cam.com/video/aS8XHZ6NM3U/v-deo.html or the one explaining IRR vs WACC ua-cam.com/video/ZuH_q5crAWg/v-deo.html and see if they help clarify.
could anything other than WACC be used to calculate NPV?
Hello Denis! Yes, some companies use a hurdle rate, which is kind of a "rule of thumb" version of WACC: ua-cam.com/video/8EyFLdOTuHU/v-deo.html
@@TheFinanceStoryteller Thank you! So hurdle rate is basically WACC adjusted for risk . I was thinking of something that doesn't contain a "pseudo-science" element.
Well, you could push both NPV and WACC aside, and evaluate projects on their convexity or concavity potential. See Nassim Taleb's "The Black Swan" and "Antifragile".
I wed 100 euro dat jij Nederlands bent hahaha
Erg goede video verder!
Klopt!!! :-)
🥳
Does WACC can be different in each year?
Hello! There are two ways I can read your question:
1) If I do a DCF analysis on a certain company now (in June 2024), can the WACC be different from the one that I used in a previous DCF analysis for the same company a year ago or two years ago? Yes, especially as interest rates have changed significantly over time.
2) Can I apply a different WACC to cash flows occurring in different years in the same DCF model? No, that makes it unnecessarily complicated. When calculating the present values, you already apply the time value of money ("lighter" on earlier years, "heavier" on later years) by doing WACC^1 for year 1, WACC^2 for year 2, etcetera.
See also my video on DCF: ua-cam.com/video/Wez6_1-9WiU/v-deo.html&pp=gAQBiAQB
how to calculate discount rate of limited liability company ???
Hi Lkhagwa! You might be better off taking the "rule of thumb" hurdle rate approach: ua-cam.com/video/8EyFLdOTuHU/v-deo.html
Brilliant!!!
Thank you, Jake!
In short - WACK
Just kidding, good video thank you very much!
Oooooh! I love that one!!!! WACC is WACK. Hahaha. Thank you for watching and commenting, Mr or Mrs Test User.
Is debt same as total liabilities?
Hi Stefan! Yes, in the context of WACC calculations, debt and total liabilities are normally used as synonyms. Even though you could argue that you should only take interest-bearing debt into account, and not other non-interest-bearing liabilities like accounts payable, accrued liabilities and deferred revenue.
@@TheFinanceStoryteller thank you so much sir! 🙏
Why we use wacc (cost of capital) as discount rate? I understand discount rate , but using wacc as discount rate i didnt get that.
For. Eg. If there are future cash flows from year 1 to year 5 for a Bond, then we can apply the market discount rate (prevailing interest rate ) to calculate present value.
Or in case of companies we can simply discount with the rate of return we want.
So what does discounting the future cash flows with the cost of capital means? Why are we reducing the value of future cash flows by dividing with wacc? What does that reduction in value represents?
My answer to all the above questions related to wacc is (correct me if i am wrong):- wacc represents the cost of capital , so (1+wacc%)^1 means amount to be paid to equity & debt holders of the company 1 year from now , so FCFF1 ÷ (1+WACC%)^1 Represents the {(leftover or present)???- not sure} amount . Similarly FCFF2,FCFF3 etc.
Hello Krishan! WACC is used by large corporations as the discount rate, because they want to keep the capital structure (the relative amounts of debt vs equity) going forward the same as it is currently. In other words, every new project they invest in, is assumed to replicate the existing capital structure.
Project managers tend to argue "why don't we just finance it with debt", as that would be cheaper. You can't do that structurally, as your debt-to-equity ratio goes through the roof, making the company riskier, and thereby lowering the credit rating, increasing the cots of borrowing, and causing the shareholders in a more highly leverage company to demand bigger returns.
No, we don't actually pay equity and debt holders through a WACC calculation. Yes, there will be interest due on loans, and yes, the company may or may not pay a dividend to shareholders, but that is a separate discussion.
Discounting future cash flows with a discount rate (WACC or hurdle rate), takes the time value of money into account, and translates everything to present value equivalents.
@@TheFinanceStoryteller but why do we discount the future cash flows with the wacc (or hurdle rate or cost of capital)?what does that mean? You might say to get the present value, but that's not the answer i am looking for. I want to know why do we use wacc as discount rate. How discounting with wacc give us the present value of a stock?
I understand wacc as weighted cost of capital i.e. wacc is used to calculate cost of capital. But using that wacc & putting it in a dcf model "as discount rate" to calculate the "present value" of a stock that i'm not able to grasp?
Again let me tell what & how i am thinking about this problem:- lets say that i want to make 15% on my investment (using my required rate of return as discount rate). Then i am going to use that as my hurdle rate. So i am going to discount the future cash flows of a company with this discount rate & get the present value.
But, on the other hand, if i apply the company's wacc% for e.g. 10% (as calculated by wacc) as hurdle rate or discount rate then it means that i am thinking from the company's point of view. Then it means that 10% return is a must for the company. So we discount with that 10%
In short my answer to the question of using wacc (10% ) as discount rate is :- 10% wacc means the weighted cost of keeping the equity holders invested in the company & calculated actual %age cost of debt. So that 10% is the damage/loss the company is taking. So it becomes the hurdle rate. So 10 % loss (wacc) = 10% discount rate.
@@KrishanSingh-gz9op I am not am sure which question you would like me to answer, if you write long rants like this.
WACC goes up if the perception of the risk profile goes up. A company with lots of assets that has a proven track record might have a WACC of for example 8%. A startup that has an idea but no commercialized product yet, might have WACC of 20%.
If both of these companies forecast a similar annual free cash flow for the next 10-20 years, then the current valuation of the first company will be higher than that of the second, as the present values of those expected future cash flows are different due to applying a different WACC.
Maybe watching one of the valuation case studies of Scott Rubin might help: youtube.com/@ScottsStockDueDiligence?si=FvPlK9x-ms5jAZp9
im so angry i didnt find out about this channel years ago
Sadly, we can't travel back in time. The next best thing is to watch as many Finance Storyteller videos right here right now. 😉
@@TheFinanceStoryteller if we could i would probably just not procrastinate and i wont have to shove 6 months worth of lectures in my head in one week
@@TheFinanceStoryteller btw i love how you keep repeating the same information in every video, helps with the shoving
Let's maximize what you can still achieve in a week... Here's a playlist around NPV, IRR, WACC and related concepts that might have some useful videos for you: ua-cam.com/video/N-lN5xORIwc/v-deo.html
Treasury bills are 100% risk free if the government issues them in the domicile currency.
I disagree with you on that. Risk free to whom?
@@TheFinanceStoryteller They are risk free in the sense that the investor will get paid, as the government has the option of printing money to repay debt. Lets say you invest in US government t-bills (a country that issues debt in domicile currency), you will always get the return, as US treasury always has the option of printing money. The US government can never default on its debt, because it only issues debt denominated in its domicile currency. On the contrary, ie Greece can default, because it issues debt denominated in Euros, which is not a domicile currency.
I think you suffer from platonification (tendency to simplify and overgeneralize). Don't confuse low risk (however remote the chances are) with never.
@@TheFinanceStoryteller I don't think I am simplifying. It's just not complicated. Take for example Weimar Germany WWI reparations. The German debt was denominated in gold marks. Germany printed unlimited amounts of paper marks to buy convertible currency to return its debt, and ended up paying I think 2/3 the initial debt.
Ah. So any lender to Weimar Germany got part of the debt paid back, and that money was actually worthless in terms of purchasing power due to hyperinflation of unlimited printing of paper marks. Risk free for the investor???
SORRY WHAT IS VALUE FIRST ? SORRY
Companies create value for their shareholders if they generate free cash flow, and that free cash flow grows year after year after year. Another perspective is to say that value is created when the return on invested capital exceeds the cost of capital.
Doing this as an Engineer, Finance is stupid easy lmfao. Y'all need to relax with what they paying some of you to do this haha.
Agree! However, the tough part of finance is the area where judgments are involved: "based on the facts and circumstances, we believe this is the right way to record the transaction". And then finance people might disagree with their auditor on what is the correct way to apply a certain (generic) accounting standard to a specific situation. In other words, it's not always a 0 or 1 decision.
Another thing that winds people up is that some concepts are not uniformly defined, for example different companies have different definitions of what is or what is not part of working capital, free cash flow, etc.
Hope this helps! Wishing you a lot of success in your learning journey.
BMM PLC is considering Bee Keeping Business beginning 2015 E.C. The following are project requirements and costs related to the new project:
o Proposed number of hives: 600 (acquires for Br 4,000 each hive including bees). Straight line method of depreciation is to be used with salvage value of Br 200,000. Site preparation costs (to be added to cost of hives) total Br400, 000.
o Production equipment will cost the PLC Br640,000. Straight line method of depreciation is to be used with salvage value of Br 40,000.
o The cost of office equipment and furniture totals Br420,000. Straight line method of depreciation is to be used with salvage value of Br 15,000.
o The monthly rent expense will be Br 250,000 for offices store areas and other facilities.
o Number of people to be employed… 30 (the average wage of each employee is Br 8,000 per month and becomes Br 10,000 per month starting from year 2).
o Raw materials… Sugar and other carbohydrate products….. 2 kilogram per hive per day for 365 days a year. The cost per Kilogram of these raw materials will be Br 70 in year 1 to year 3 and Br 80 from year 4 to year 5.
o Cleaning supplies worth Br 7,500 per month.
o Selling and other administrative expenses total Br 100,000 per year.
o Production:
o 12,000 kilograms of honey per month (Sold for Br 250 per kilogram in year 1 and will increase by 20% each year starting from year 3)
o 6,000 kilograms of byproduct for wax manufacturing per month (sold for Br 40 per kilogram in year 1 and will increase by 10% each year starting from year 2)
o The project needs the following minimum balances on hand throughout the life of the project:
2
a. cash balance of Br120,000 per month
b. Raw materials inventory of 30 days.
c. Cleaning Supplies of 2 months
o Preparatory study costs: Br 150,000 (Br 50,000 is already spent). Such costs will be amortized over 5 years on straight line basis.
o The PLC will finance this project using target capital structure of 60% bank loan and 40% equity. The bank loan will be obtained at 15% annual interest rate. Interest will be paid at the end of each year & the principal will be repaid after 5 years. Equity will be raised by issuing Br1,000 par value ordinary shares with market price of Br1,500 per share. The dividend per share for year 1 will be Br120 and the constant growth rate will be 6.7%.
o Tax rate is 30%.
o Project’s life is assumed to be 5 years.
o The useful life of property, plant & equipment items is assumed to be the project’s life.
o The project’s discount rate will be the weighted average cost of capital.
o Annual interest payments on debt used to finance this project would be a tax-deductible expense.
o All purchases and sales are on a cash basis.
Instructions:
1. Calculate the Weighted Average Cost of Capital (WACC) for the project. Hint: Use dividend capitalization model (constant growth model) to calculate cost of equity.
2. Determine the investment cost of the project
3. Prepare the projected income statement for each of the five years
4. Determine the relevant cash inflows of the project for each of the five years
5. Determine the relevant cash outflows of the project for each of the five years
6. Determine the net cash flows of the project for each of the five years
7. Evaluate the feasibility of the project using
a. Payback period method where the acceptable time limit is 2 years
b. NPV
c. IRR
What's the purpose of you posting the above? I am not going to do your homework for you!
I saw your video ones again but I am unable to work the question and I want to give me some clue related to the question Thanks
Sorry, but it is such a long story/assignment, that I classified it in the TLDR category.