If you're a stock investor, it's essential to understand the WACC (Weighted Average Cost of Capital) calculation. This will help you make sound investment decisions and maximize your profits. In this guide, we'll walk you through the WACC calculation step by step so you can apply it to your investments. We'll also discuss some factors that can affect WACC, such as risk and inflation. So whether you're just starting out in the stock market or you're a seasoned pro, read on for everything you need to know about the WACC calculation!
What is WACC, and why is it important for stock investors to understand it?
WACC stands for the weighted average cost of capital. It measures the average rate of return that a company must earn on its investments to satisfy its shareholders. The WACC calculation is important for stock investors because it can help you assess a company's financial health and make investment decisions accordingly.
Based on the WACC, investors can asses how efficient the company is at deploying its capital. Great firms will have a lower WACC and vice versa. If a firm's WACC is higher than its return on invested capital, the company is destroying shareholders' value instead of creating it. This is a big red flag because it indicates that the company is generating lower returns than the costs it has to raise capital.
On the other hand, if a company's WACC is lower than its return on invested capital, it is using the capital it raises efficiently, creating value for shareholders. This indicates that the company is generating higher returns than its cost to raise capital.
This information is essential for stock investors because it can help you assess a company's financial health and make investment decisions accordingly. If you're considering investing in a company, you can use the WACC to determine whether or not it's a wise investment.
How do you calculate WACC using the weighted average cost of capital formula?
There are a few different ways to calculate WACC, but the most common method is using the weighted average cost of capital formula. This formula considers a company's debt and equity, as well as the cost of each. To calculate WACC, you'll need to know the following information:
- The market value of a company's debt
- The market value of a company's equity
- The cost of debt
- The cost of equity
You can find this information in the company's financial statements and online sources. Once you have all the necessary information, you can plug it into the WACC formula:
WACC = (E/V) x Re + ((D/V) x Rd x (100-Tc))
Where:
E/V = market value of equity/total market value
Re = cost of equity
D/V = market value of debt/total market value
Rd = cost of debt
Tc = corporate tax rate
Once you have all the information plugged into the formula, you can solve for WACC.
Let's calculate the WACC step by step for Apple.
WACC step-by-step calculation for Apple
Calculating the market value
The market value of Apple is simply its market capitalization or market cap, which you can easily Google or get on your spreadsheet using Wisesheets.
Calculating the market value of debt
The best way to calculate this value is to check online to see if the company has any outstanding bonds and, from there, find the years to maturity, interest, and total debt.
In the case of apple using this information from its current bonds and financial statements, we get the following information:
Years to maturity = 5
Interest = 2,645,000,000
Total debt = 124,719,000,000
Cost of debt = 3%
Therefore the market value of debt is calculated as follows:
Market value of debt = 2,645,000,000*((1-(1/1+3%)^5))/3%+124,719,000,000/(1+3%)^5
Market value of debt = 93,541,040,762
Calculate the cost of equity
There are two options for calculating the cost of equity. The first is to use the CAPM and the second is to use the dividend cost of equity calculation.
Calculating the cost of equity using the CAPM is as follows:
Cost of equity = risk free rate + beta x (market return – risk free rate)
Where:
Risk-free rate = the current yield on a government bond with a similar term to the maturity of the company's debt. For example, if the company has 10-year bonds, you would use the 10-year government bond yield.
Beta = a measure of a stock's volatility in relation to the market. You can find beta values on sites like Yahoo Finance.
Market return = the return you would expect to earn on the market as a whole. This is also known as the equity risk premium and can be found on sites like Investopedia.
For this calculation, we'll use a risk-free rate of 3.199%, a beta of 1.23, and a market return of 7.5%. Plugging these values into the CAPM formula, we get:
Cost of equity = 0.03199 + 1.23 x (0.075 – 0.03199)
Cost of equity = 0.0848923
The other method for calculating the cost of equity is the dividend cost of equity calculation, which is as follows:
Cost of equity = ((dividend per share)/(price per share)) + growth rate
Where:
Dividend per share = the most recent dividend paid by the company
Price per share = the current stock price
Growth rate = the expected growth rate of dividends. This can be found in a company's annual report or on sites like Morningstar.
For this calculation, we'll use a dividend per share of $0.23, a price per share of $155.81, and a growth rate of 0.06. Plugging these values into the dividend cost of equity formula, we get:
Cost of equity = ((0.23)/(155.81)) + 0.06
Cost of equity = 0.06147615685
Calculate the tax rate
The tax rate is the percentage of income that a company pays in taxes. This can be found in a company's annual report or using Wisesheets.
For this calculation, we'll use Apple's tax rate in 2021 of 13.30%.
Calculate the WACC
Now that we have all the necessary information, we can plug it into the WACC formula:
WACC = (E/V x Re) + ((D/V x Rd) x (Tc))
Where:
E/V = market value of equity/total market value
Re = cost of equity
D/V = market value of debt/total market value
Rd = cost of debt
Tc = corporate tax rate
For Apple, we get:
WACC = ((2,503,991,361,536/(2,503,991,361,536+93,541,040,762))*8.49%)+((93,541,040,762/(2,503,991,361,536+93,541,040,762))*3%*(1-13.30%)
WACC = 0.0827792827 or ~ 8.2%
You can use this same process to calculate the WACC for any publicly traded company. Again, remember to use the most recent information available, as WACC is a forward-looking metric.
WACC Google Sheets template
You can use the WACC Google Sheets template below to calculate the WACC for any publicly traded company. Simply input the necessary information into the green cells, and the template will do the rest.
Click here to download the WACC Google Sheets Template.
Note that part of the data from the template comes from Wisesheets, which gets the data from the company's financial reports. You can get your free trial account here.
What are some factors that can affect a company's WACC calculation?
There are a few different factors that can affect the WACC, such as risk and inflation. Let's take a closer look at each of these factors:
Risk: The higher the risk of an investment, the higher the expected return. This is because investors require a higher return to compensate them for the increased risk.
Inflation: Inflation can reduce the value of cash flows, which increases the cost of capital and, therefore, the WACC.
These are just a few of the factors that can affect WACC. To get a more accurate picture, you should consider all the factors affecting a company's WACC calculation.
What potential risks and rewards are associated with investing in stocks based on their WACC values?
Some potential risks and rewards associated with investing in stocks based on their WACC values include:
- Risk: Stocks with a high WACC are generally considered riskier than those with a low WACC. This is because they have higher costs of capital, which means they will have to generate higher returns to meet their financial obligations.
- Reward: Stocks with a low WACC are generally considered less risky than those with a high WACC. This is because they have lower costs of capital, which means they will need to generate lower returns to meet their financial obligations.
In general, stocks with a higher WACC are considered more risky investments than those with a lower WACC. However, these stocks also have the potential to generate higher returns. So, it is important to consider both the risks and rewards associated with investing in stocks based on their WACC values before making any investment decisions.
How can you use WACC to make informed investment decisions?
WACC can be a valuable tool for making informed investment decisions. By understanding how WACC is calculated and what factors can affect it, you can use this information to make more informed investment choices.
For example, if you are considering investing in a stock with a high WACC, you should first consider the risks associated with such an investment. You should also consider the potential rewards and whether the expected return is sufficient to offset the risks.
On the other hand, if you are considering investing in a stock with a low WACC, you should first consider the potential rewards associated with such an investment. You should also consider the risks and whether the expected return is sufficient to offset the risks.
By taking the time to consider both the risks and rewards associated with stocks with different WACC values, you can make more informed investment decisions that will likely lead to success.
Conclusion
WACC is an important metric for stock investors to understand and calculate. There are a few different factors that can affect WACC, such as risk and inflation. Stocks with a higher WACC are generally considered to be more risky investments than those with a lower WACC. However, these stocks also have the potential to generate higher returns. So, it is important to consider both the risks and rewards associated with investing in stocks based on their WACC values before making any investment decisions.
While WACC can be a helpful tool for making investment decisions, it is only one metric that should be considered. Other factors such as company history, financial stability, and expected future performance should also be taken into account. By considering all of these factors, you can make more informed investment decisions that will likely lead to success.
Happy investing!
