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.”