WACCs are Wack

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.
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My Love-Hate Relationship with DCFs

One of the biggest changes in my investing process over the past year has been my increasing usage of discounted cash flow (DCF) models. I used to rarely use them and now I build DCF models for every company I’m serious about. I want to start by reviewing the major things that a lot of investors (including myself) don’t like about DCFs and how I’ve gotten over these concerns.
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