The weighted average cost of capital (WACC) measures what it costs a company to acquire funding. Internally, it’s the hurdle rate a CEO should be using to decide on what projects to allocate money to. If it costs a company 8% per year to acquire their debt and equity, they shouldn’t be green lighting projects that return 5% per year. That’s lighting money on fire. Externally, we as investors can compare a company’s return on invested capital (ROIC) to its WACC to evaluate the quality of the company and the CEO’s capital allocation skills.

A CEO’s goal is to invest capital at a higher rate of return than what that capital costs the company to acquire. If he or she is able to do this, the value of the company will grow. If he or she invests in projects at low returns, the company’s value will shrink. Similarly, as an investor, my goal is to invest my own capital at a rate of return that surpasses what I can easily achieve elsewhere (such as a broad market index fund). My hurdle rate for investing capital is different than that CEO’s. Yet, the traditional discounted cash flow method suggests I use the company’s cost of capital as my own hurdle rate. This doesn’t make sense to me.

The discount rate I use for almost all scenarios is 11%. The stock market has historically returned around 10% per year (including dividends). Going forward, I expect the average annual returns to come down a bit as the US is more mature and bigger than it historically has been. As every large cap company knows, it’s harder to grow from a larger base. Because of that, I think a 9% expected return for the future is fair. If I can’t beat that 9% annual return, then all I’ve done is waste a shit ton of time and money. But I manage other people’s money too, so my clients need to earn that 9%, net of my 2% fee. 9% + 2% = 11% (my math teacher taught me to always show my work!). That’s my minimum hurdle rate for investing and thus the discount rate I use when doing discounted cash flows. However, if I didn’t manage money, I’d use 9% as my discount rate which, at least in theory, would make more companies investable for me. Maybe you think my 9% estimate for future market growth is too high or too low so you use something else. Maybe you manage money but charge a different fee. The point is that every investor should have a different hurdle rate for their investment returns and it has nothing to do with a company’s capital structure.

If I do a discounted cash flow analysis and the company ends up meeting my expectations exactly, I will earn that 11% per year that I used as the discount rate. This is why discount rate is sometimes used interchangeably with expected return (and hurdle rate). But there are a lot of companies that have around a 7% cost of capital. Many investors then use this 7% as their own hurdle rate in the valuation, but I’m betting most of those investors (especially the ones that manage money) would not be happy meeting that hurdle rate.

Ultimately, spending hours deciding on the best discount/hurdle rate to use for every stock is probably a waste of time. However, I do think it’s something worth thinking about to decide on a number that suits your situation. Using a company’s cost of capital, especially when it’s low, can yield massively different expectations compared to using your own hurdle rate. With that being said, I like the way this guy put it on Wall Street Oasis a couple years ago: “The best investments are not made because you nailed the discount rate in percentage terms and if making an investment decision comes down to whether you go with a 10% or 12% discount rate I can say with almost absolute certainty that it won’t be a good investment.”

Isn’t the Return – Cost more important than the level of the cost ?

Ceteris paribus I would rather own a company earning 3% for a cost of 1% than 8% and 7%.

LikeLike

Definitely important, but your example really isn’t possible. By my calculation (which I mentioned in my last post on DCFs) a company’s cost of capital will never be below 6-7% because inflation, an equity risk premium and a risk free rate are always present. If we modify your example and say a company earning 12% on 8% is better than another earning 15% on 14%, then yes I would agree 🙂

LikeLike

But then, based on your method of using the fixed 11%, how would you have managed to pick the first one ?

LikeLike

I think we’re mixing two different concepts. When I’m valuing a company I discount my estimate of their future cash flows by 11% per year. This is what I estimate my minimum annual returns need to be over the long-term (i.e. my hurdle rate). What a company earns (ROIC) on their cost of capital (WACC) is separate. I’d prefer a company earnings 12% ROIC on a 8% WACC over the 15%/14% alternative because there’s more margin for error there. ROIC and WACC aren’t precise (and different investors have different ways to calculate each) so if I think a company is barely earning more than their WACC there’s a decent chance I’m wrong and they’re actually destroying value. If a company’s ROIC is well above their WACC then even a few percentage points of error still means they’re comfortably creating value for themselves.

LikeLike

I understand but I still can’t see how your DCF would allow you to invest in the 8% company if you have fixed your hurdle rate at 11%.

LikeLike

The 8% is the company’s cost of capital, basically what it costs them to raise money (equity + debt). The lower the number the better because it means banks are willing to loan them money at a relatively low interest rate. All things being equal, a low cost of capital is better than a high one. My hurdle rate is the minimum I need a stock price to grow each year (over the long-term) to achieve satisfactory returns. This 11% hurdle rate is what I discount my estimate of a company’s future cash flows at to account for the time value of money. The lower the company’s cost of capital, the higher their future cash flows will be due to lower interest payments. So the two numbers really don’t affect each other. They’re both used in the same analysis, but they aren’t compared to each other.

LikeLike

So you’ve fixed the discount rate but the spread appears in the numerator ?

LikeLike

Travis,

The discount rate used by a rational value investor to value future corporate cash flows should be based on two things only: (a) risk-free interest rates (e.g., Treasury bond yields) and (b) how much *uncertainty* there is in those future cash flow estimates. In other words, DCF discount rate = risk_free_rate + risk_premium. The risk premium ought to have nothing to do with the investor’s personal situation (fees charged to clients) and everything to do with the stability/predictability of the cash flows themselves. For example, cash flows generated by an income producing real-estate business are more stable than those generated by an E&P (oil and gas) business; therefore, the discount rate used in a real-estate DCF analysis should be lower than that used in an E&P DCF analysis. Using the same discount rate on all DCFs (e.g., the 11% you suggested) is clearly incorrect.

Once you derive the fair value based on a rationally chosen discount rate, you can then compare the current price to fair value and determine whether the gap is large enough to justify making the investment. I suppose you could consider the fees charged to your investors in this step – i.e., only make an investment if the price/value gap is large enough to justify your fees.

Regards,

aagold

LikeLike

Yes, that is the traditional way of thinking about discount rates (and is what I was initially taught). Maybe what I use is more of a personal hurdle rate vs a true discount rate. Whatever it is, I like my method 🙂

LikeLike

Ok, to each his own, but here’s a thought experiment for you.

Consider two businesses, A and B. Let’s say an investor estimates that the *mean* cash flow stream generated by A and B are identical but the spread between the max and min (bull and bear) cases for B is twice as large as it is for A. If you apply the same DCF discount rate to A and B then you’ll end up with the same fair value for both whereas a rational value investor will assign A a higher valuation than B. Agree or disagree?

– aagold

LikeLike

Agree. And thankfully I’m a human, not a robot, and would notice something like that. As I alluded to in the last paragraph in this post, there are many factors more important to an investment thesis than what number a DCF spits out. Predictability (and range) of future cash flow is certainly one of those things that’s important to think about, whether a DCF explicitly accounts for it or not.

LikeLike