Monday, June 3, 2013

Cookbook WACC Estimates: Wrong Recipes?

The weighted average cost of cost (WACC) is used to discount a target’s expected free cash flows (EBITDA less taxes , CAPEX and working capital increases) to determine its value. The target’s business risk profile and the intended capital structure are used to arrive at WACC. Estimating WACC suffers from severe application issues-especially in the current unsettled quantitative easing environment.

The WACC cookbook approach embedded in many financial models involves the following steps:

                  1) Determine a capital structure based on target ratings. For example, a BBB
                      rating target for an industrial firm usually means 40-50% debt to capital

                  2) Estimate the cost of debt (Kd) for firms with that capital structure based
                      on observations from sources like Bloomberg.

                  3) Calculate the cost of equity (Ke).

                  4) Combine the after tax debt cost with Ke using appropriate weights to get WACC.

The weak link in the above steps is calculating the unobservable Ke.  Most firms use the capital asset pricing model (CAPM) to calculate Ke. The calculation involves adding a risk mark up to the risk free return (Rf) based on an asset’s units of risk (beta-B) times the price per unit of risk (market risk premium- MRP). The inputs used can vary considerably. Note some of the issues and choices:

1)     Rf: Treasury bills,5 , 10 or 30 year bond? Usually try to match with the asset’s expected life.

2)     B: what period and which one-Value Line, Bloomberg or forward looking fundamental B such as Barra?

3)      MRP: historical 1926-2013 (e.g. Ibbotson-Morningstar), implied forward (e.g. Damodaran), survey, etc. The range runs from around 2%-8%. Many use 6% as a shortcut.

 WACC ranges based on differing input choices can be large. For example, the difference between the high and low estimates for Target Stores is 400 basis points. This has huge implications when making capital allocation decisions. A related problem is that CAPM (and to be fair, all equity models) are estimates of truth. (As we have noted, Value is Estimated, Price is Paid). Alternative multi factor models like the Fama-French 3 factors offer some hope in addressing the CAPM deficiencies.  However, any mechanistic run the spreadsheet approach to calculating discount rates, is trouble in the brewing.  

Finally, evidence indicates that the market price of risk changes based on investor risk aversion and central bank polices. For example, Fed QE policies have depressed interest rates like Rf. Evidence indicates the MRP varies inversely with rates. Thus, in the current low rate environment, MRP inputs can be under estimated.

Bottom line-forewarned is forearmed. Beware of the seductive simplicity of cookbook recipes built into many valuation models. Investors like Warren Buffett avoiding using WACC for the reasons outlined above. He uses certainty equivalent cash flow estimates discounted at the observable (as opposed to the calculated WACC) Rf rate. For those using WACC- I suggest using a range of different estimates based on alternative inputs and models. The key is to use judgment before cranking out numbers. In so doing you can avoid getting indigestion from using the wrong recipe.


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