After we have completed the first step in arriving at an EPV (earnings power value) which is to calculate distributable earnings (Think of after-tax owner earnings using true maintenance capex instead of depreciation) for the company. Now we need to determine the appropriate cost of capital to use in the equation of EPV = Adjusted earnings x 1/R, where R = WACC.
Calculation of the WACC
Professional finance calls for a calculation of the weighted average cost of capital, known affectionately as the WACC.
There are three steps:
- Establish the appropriate ratio between debt and equity financing for this firm.
- Estimate the interest cost that the firm will have to pay on its debt, after taxes, by comparing it with the interest costs paid by similar firms.
- Estimate the cost of equity. The approved academic method for this take involves using something called the capital asset pricing model (see link below), in which the crucial variable is the volatility of the share price of the firm in question relative to the volatility of the stock market as a whole, as represented by the S&P 500 . That measure is called beta, and as much as it is beloved by finance professors, it is viewed with skepticism by the value investors. (98) Value Investing (Greenwald).
CSInvesting: Why because price movement is not risk! Risk always has an adjective preceding it like business-risk, management-risk, financial risk, regulatory risk, etc.
An alternative approach is to begin with the definition of the cost of equity capital: what the firm must pay per dollar per year to induce equity investors voluntarily to provide funds. This definition makes determining the cost of equity equivalent to determining the cost of any other resource. The wage cost of labor, for example, is what employers must pay to attract that labor voluntarily. There is no need to be esoteric about how to calculate the cost of equity in practice. We could survey other fund raisers to learn what they feel they must pay to attract funds. Venture capitalist in the late 1990s told us that they believed they had to offer at least 18 percent to attract funding. Venture investments are clearly more risky than those in WD-40; it is understandable that potential investors would demand higher returns. Alternatively, we could estimate the total returns—dividend plus projected capital gains—that investors expect to obtain from companies with characteristics similar to WD-40. This method, the details of which we avoid here, produces a cost of equity of around 10 percent. Because long-term equity yields are about 12 percent per year, and because WD has a much more stable earning history than the average equity investment, 10 percent meets the reasonability test.
Risk vs cost of capital
The riskier (business, financial, etc.) the higher the cost of capital should be, but to say a great deal more with both confidence and precision is presumptuous. Because value investors are attracted to companies that have steady and predictable income streams, it may be enough to use the federal bond rate and add a percentage point or two. We can test that against a back of the envelope calculation of the WACC. For a company like WD-40 , with stable earnings unaffected by the business cycle, a capital structure of 50% debt and 50% equity is reasonable.
If the interest rate it has to pay is 9 percent, the after-tax cost becomes 6 percent. Again, because of the stability of its earnings and its share prices, we estimate that the equity cost will be 10 percent. Averaging the two gives us a WACC of 8 percent, which equals a federal bond rate of 6 percent plus 2 percent. Eight percent for the weighted average cost of capital seems reasonable.
If we intend to compare the EPV to the market price, we need to make one final adjustment. The EPV assumes that all the capital is equity capital; it ignores both interest paid on debt and interest received on cash. If there is debt, it has to be subtracted from the EPV. If there is cash in excess of operating requirements, it should be added back. Only then can we compare the total EPV with the market price of the equity.
