Once we have projected out a company's free cash flow for the determined projected period, usually five years. We then need to determine the cost of capital rate that we use to discount the cash flows to arrive at a present value. We'll get into the mechanics of the present valuing process later. But first let's look at how we derive the cost of capital. The most commonly used discount rate for the DCF valuation method it is what is known as the Weighted Average Cost of Capital, commonly referred to as WACC. We use this rate to discount both projected free cash flows, as well as the terminal value a concept we will cover later. This rate is meant to reflect the rate of return that an investor would expect to earn in an alternative investment and with a similar risk profile. It is called weighted average because it takes into account both the cost of the company's debt. After taking into account the effect of the tax benefit associated with interest expense and the company's equity. This is a good depiction of the WACC formula. First assess the ratio of debt in the capital structure to equity in the capital structure. Then multiply the debt percentage times the after tax cost of debt. Multiply the equity percentage by the cost of equity and sum of the two to arrive at WACC. In order to complete this analysis, we need to complete the following steps. Number 1, determine the Targets Capital Structure. In other words, percentage debt versus percent equity. Number 2, estimate the Cost of Debt known as ("rd"). Number 3, estimate Cost of Equity known as ("re"). And number 4, calculate the WACC by summing the cost of debt and the cost of equity. The first thing that we determine is the target capital structure. This is measured as the ratio of debt and equity as a percentage of the company's total capitalization. Total capitalization is defined as debt typically measured as debt on the balance sheet plus the market value of equity, which is different than the equity value on the balance sheet. For public companies, we generally use their existing capital structure analysis unless there is evidence to suggest that the current structure is not going to be reflective of what it will be in the future. For example, if the business is an early stage company and it's fully equity funded. But the expectation is that the company will ultimately raise debt and have a mix that is consistent with its peer group. For private companies since we don't have a readily observable market capitalization, we typically use the mean or median ratio of the comparable group. This is the same group that we will use to calculate the cost of equity and the same group we used in our comparable company valuation analysis. After we determine the target capital structure, we then assess the cost of debt. This is reflected on an after tax basis using the company's marginal tax rate. Companies generally can deduct interest expense and thereby reduce its overall cost of debt. And the cost of debt considers the numbers of factors including the company's size, sector, outlook, cyclicality, credit ratings and credit statistics and cash flow generation. For public companies, we will typically look at their balance sheet and look at the yields on their current debt and use a weighted average based on their debt outstanding. For private companies, we would look at the interest rates that similarly rated companies are paying in the market. All in all determining the cost of debt is relatively straightforward and not subject to significant judgment. On the other hand, the assessment of the company's cost of equity can be a little more tricky. There is no readily observable cost of equity that you can reference as there is with debt. So we must use more judgment and we employ a convention called the Capital Asset Pricing Model, also known as CAPM. CAPM is reflected by the following formula. The Risk-Free Rate plus the product of Levered Beta and the Market Risk Premium. In addition, we will consider adding a size premium for when we look at companies with smaller capitalization. Let's look at each of these in turn. The risk-free rate is the expected rate of return on what is considered a riskless security. When looking to companies based in the United States, we generally look at a Treasury rate of either a 10 or a 30 year duration. Personally I prefer to use the 30 year Treasury since the purpose of the DCF is to calculate the present value of all cash flows Into perpetuity and that rate is the longest duration one available. This reference rate can be easily obtained from Bloomberg, Capital IQ or other online sources for market data. The next part of the CAPM formula is what is known as Beta. The technical definition of beta is a measure of stock price variability in relation to the overall stock market. If a stock has a beta greater than 1.0 for every dollar that the stock market moves, you would expect the stock to move more than $1. If the stock has a beta of less than 1.0 For every dollar that the stock market moves, the stock would move less than $1. Hence, a higher beta signals higher volatility. It is more common in high growth stocks that are more prone to wider stock price swings versus a more defensive or conservative company that is considered to be much more stable. And the way that CAPM works all else being equal higher beta stock would have a higher WACC. This reflects the fact that these stocks have greater risk. Similar to the risk-free rate for public companies, beta can be obtained from Bloomberg or capital IQ. For private companies, we do not have an ability to readily identify beta since it is not a traded security on an exchange. As a result, we calculate an implied beta from our comparable group and use that for our CAPM analysis. One caveat however, the beta that we gather from Cap IQ or Bloomberg for a comparable group is levered beta. Since it's calculated on an as is basis with the company's current capital structure. Since the capital structure for each comparable maybe different from each other and from that of the company we are seeking to value. We go through a process of unlevelring, all of the selected comparable company betas, calculating a mean and medium for that group. And then re-levering it based on the capital structure we have selected within our analysis. To unlevel a company's beta we take the levered beta and divided by the sum of 1 and the debt to equity ratio, multiplied by the marginal tax rate as shown in the formula on this slide. Once we have done this for all of the comparable companies, we take the average of the newly unlevered betas. And then Re-lever that average beta by the target capital structure of the company we are seeking to value. We do this by multiplying the unlevered beta by the sum of 1 and the debt to equity ratio, multiplied by the marginal tax rate. Basically the inverse of what we did to unlevel the beta. This gives us the beta that we will use in our CAPM formula. The next component of CAPM is what is known as the market risk premium. This is the spread of the expected market returned over the risk-free rate. It is a reference rate that we can find from a firm called Ibbotson which is now owned by Morningstar that has tracked all the way back to 1926. Frankly, I get this number directly from the internet by typing in the market risk premium into Google. I just did that and came up with 5.6%. The last component of the captain formula is an optional one. It is called the size premium or sometimes known as the small company risk premium. The concept is that smaller sized companies are riskier and have a higher cost of equity. So we add on a size premium to the end of cap to get our cost of equity. Again, this is a reference rate that we can get from a table that is published by Duff & Phelps. This is the size premium table that I reference. It breaks companies down to mid, low and micro CAPs or undersized deciles. I always use the deciles as I think it's a little more precise. And for the lowest decile, it further breaks it down into four quartertiles, which provides more precision. So for example, if a company had an expected market capitalization of between 100 million and 185 million, I'd follow the table and see that the size premium I would use is 7.55%. Again, this is a direct add onto the CAPM formula. So pulling all of this together, we can look at the output of our WACC model template. We input all of the debt and equity related variables that we have discussed in this session and it calculates the weighted average cost of capital that we use in our DCF. It is important to note that we sensitize the WACC based on the capital structure and in this case the cost of debt. This gives us a perspective of how changes in these two items can impact the overall WACC that we use. So that's the end of our WACC discussion. Thanks for hanging in there with me. Have a great day and good luck.
