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The Weighted Average Cost Of Capital – When it goes up, prices go down. It’s going up…

When I was fresh out of college in the mid-90s, I landed a job at Merrill Lynch. I was an “investment banking analyst”, which meant I had no life outside of the office and hardly ever slept. I pretty much spoke, thought, and dreamed in Excel during those years.
Much of my time there was spent building valuation models. These complicated spreadsheets were used to provide an air of quantitative validation to the answers the senior bankers otherwise pulled out of their derrieres to questions like: Is the market under- or over-valuing this company? Can we defend the acquisition price we’re recommending for this M&A deal? What should we price this IPO at?

Back then, Wall Street still (mostly) believed that fundamentals mattered. And one of the most widely-accepted methods for fundamentally valuing a company is the Discounted Cash Flow (or “DCF”) method. I built a *lot* of DCF models back in those days.

I promise not to get too wonky here, but in a nutshell, the DCF approach projects out the future cash flows a company is expected to generate given its growth prospects, profit margins, capital expenditures, etc. And because a dollar today is worth more than a dollar tomorrow, it discounts the further-out projected cash flows more than the nearer-in ones. Add everything up, and the total you get is your answer to what the fair market value of the company is.

The Weighted Average Cost Of Capital

The DCF approach sounds pretty straightforward. And it is. But it’s still much more of an art than a science. Your future cash flow stream is entirely dependent on the assumptions you bake into the model. The difference between a 5% or 15% assumed EBITDA compound annual growth rate becomes huge when projecing over 10+ years.

But one assumption in the model has far more impact on the final valuation number than any other. And it has nothing to do with the company’s projected operations.

Recall that the DCF approach projects out the expected future cash flows, and then discounts them (back to what’s called a “present value”). This raises a critically important question:

At what rate do you discount these future cash flows?

Well, to address this, you need to ask yourself a few questions. How will the company be financing itself? It will need to deliver an acceptable return to both its stockholders and bondholders. What kind of return can investors get out in the market for a similar investment? If they can get a better expected rate of return, or similar return with less risk, they’ll put their money elsewhere.

Enter a calculation known as the Weighted Average Cost Of Capital (or “WACC”). Again, without getting too technical on you, the WACC looks at how a company is capitalized (what % with debt, what % with equity) and what blended annual rate of return the investors who contributed that capital expect. Once you’ve calculated the WACC, you put that number into your DCF model as the annual discount rate and — Voilà! — your model spits out the present value for the company.

It’s All About The “Risk Free” Rate

So, to recap:

  1. Companies (really, any asset with an income stream) are valued off of the present value of their discounted future cash flows
  2. This present value is highly dependent on the discount rate used

We just talked about how the WACC is commonly used as the discount rate (or, at least, its foundation). So how is the WACC calculated?

Here’s its formula (Don’t let it scare you; I’m not going to get all mathy on you here):

I want to point your attention to two important factors in this equation: the cost of equity (re) and the cost of debt (rd). The size of these variables has a big impact on the final number calculated for the WACC.

Re, the cost of equity, is made up of two components: the market’s current “risk free rate” + the “equity premium” that investors demand on top of that to hold stocks, which have more risk. Most folks use the current yield on the 10-year US Treasury bond as the risk free rate (which has hovered around 2% for the past several years).

Similarly, rd, the cost of debt, has two components: the market “risk free rate” + the premium that the company’s bondholders are charging to hold debt riskier than a Treasury bond.

The really important thing to understand here is that both of these variables are dependent upon interest rates (most notably, the yield on the 10-year Treasury). As interest rates rise, the cost of equity goes up, and the cost of debt goes up, too.

Why is that so important? Glad you asked…

The Future Of Rising Interest Rates (And Falling Asset Prices)

Most reading this are aware that we’ve been living in a falling interest rate environment for most, if not all, of our adult lives. And since the 2008 financial crisis, interest rates have been held down at essentially 0% (or even lower) by the world’s central banks:

While not the only reason, this decline in interest rates has been a huge driver behind the tremendous rise in valuations across assets like stocks, bonds and real estate over the past 30-odd years.

Which begs the question: What will happen to asset prices if/when interest rates start rising again?

Well, as I hope the above lesson on the Weighted Average Cost Of Capital hammered home, when the core interest rate rises, both the cost of equity and the cost of debt go up. Mathematically, this increases the WACC used as a discount factor, thereby reducing the present value of future cash flows. Or in layman’s terms: When interest rates rise so does the WACC, which mathematically makes valuations fall.

Now, we only need to care about this if we’re worried that interest rates will start rising. Maybe the central banks have everything under control. Maybe we’re at a “permanent plateau” of sustainable zero-bound interest rates.

Oops; or maybe not.

Remember how the “risk free rate” used in calculating the WACC is often the 10-year Treasury bond yield? Well, the yield on the 10-year Treasury started spiking last month, and is currently nearly double(!) what is was just five short months ago:

Now, it takes a little while for the higher cost of capital to ripple through the system. But we’re already seeing some immediate effects, with numerous warnings of future price corrections multiplying in today’s headlines.

Given their strict see-saw relationships with interest rates, bond prices are getting slammed:

U.S. Government: Bond Prices Fall as 10-Year Yield Hits 2016 High

Renewed selling pressure Thursday resulted in the yield on the benchmark 10-year Treasury closing at its highest since late December, wiping out the big drop earlier this year.
The yield premium that investors demanded to own the 10-year U.S. Treasury note relative to the 10-year German bund climbed to 1.99 percentage point late Thursday, the highest since 1989, the year the Berlin Wall fell. The U.S. 10-year note’s yield premium relative to the 10-year Japanese government bond also rose to the highest since January 2014.

Bond Market Slide Intensifies

Rise in yields since July has pushed the 10-year Treasury note up by more than 1 percentage point

The worst bond rout in three years deepened Thursday, hammering debt issued in emerging markets and many U.S. states and cities, while sparing large companies the brunt of the impact.
The yield on the 1-year Treasury note rose to a 17-month high, at 2.444%, up from 2.365% on Wednesday. Yields rise as bond prices fall.
The housing market has a similar see-saw relationship with interest rates, but given how less liquid homes are than bonds, it will take more time before the recent rate causes a noticeable effect on prices. That said, as expected, we are seeing an immediate impact on the market for home refinancing loans:

Mortgage Refinancings Collapse To 2016 Lows As Rates Top 4.00%

Mortgage applications tumbled 9.4% from the prior week as mortgage rates soared above 4.00% to the highest level since July 2015. The biggest driver of the decline in mortgage demand was a 16% crash in refinances – tumbling to their lowest level since the first week of January

And the industry is bracing for a pullback as “shocked” consumers react to the spike in rates:

US Housing Market In Peril As “Increase In Mortgage Rates Has Shocked Consumers”

Eventually, though, rising rates make houses less affordable, and that could lead to slowing sales, price growth and mortgage activity. Some analysts are now projecting home values will decline by the end of next year in many U.S. housing markets.

The MBA lowered its projections for next year’s new mortgage loans by 3% last week, to $1.58 trillion. That would represent a 16% drop from the nearly $1.9 trillion in mortgages that lenders are on pace to originate this year, with refinancing accounting for all of the drop.

“The increase in rate has shocked consumers…I didn’t expect it either,” said Dave Norris, chief revenue officer at LoanDepot, the 10th largest mortgage lender in the U.S. by loan volume.

(Source)

Equities have yet to soften due to the rise in rates, but the recent rally kicked off by the recent Presidential election appears to have run out of steam. More importantly, an increasing chorus of venerated investors is warning that even higher rates are coming — soon. And with them, a market correction:

Druckenmiller Joins Gundlach In Predicting 6% Yields; Expects Market Correction As Rates Rise

Druckenmiller joined Jeff Gundlach in predicting that US 10Y yields may rise to 6% over the next year or two (…)
(…) he echoed the warning made just last night by Goldman Sachs, according to which a 10Y above 2.75% would put pressure on stocks, and said that if the 10Y rose to 3%, the S&P could see a 10% correction, but warned that the market could correct well prior to that in anticipation.

Even the newly-selected Treasury Secretary Steve Mnuchin agrees that higher rates are an approaching inevitability:

“We’ll look at potentially extending the maturity of the debt, because eventually we are going to have higher interest rates, and that’s something that this country is going to need to deal with.”

(Source)

Prepare Now

The conclusion from all the above? Get ready to live in an era of rising interest rates. It’s going to be unfamiliar territory for all of us…

What will likely happen? The unrelenting upward march in asset prices we’ve enjoyed over the past several decades is over. People won’t be able to pay as much for stuff because the financing costs will be higher.

Falling asset prices should be in the cards. We’re already seeing that with bonds, and housing and stocks should follow over the next few quarters. The higher rates go, the farther the fall should be.

The Fed will be in a tough spot as this unfolds. Right now, the Fed has little power to slow things down, as the core interest rate it sets is already nearly 0%. It will likely raise rates as it can along with the market, provided it can do so without killing the economy. There’s a lot of precedent for this; historically, the Fed’s interest rate has usually followed the market vs leading it. The Fed will want to gain some maneuvering room to drop rates at some point in the future if it feels it needs to.

At some point, if we risk entering a full deflationary rout, the world’s central planners may well indeed pull out an arsenal of tricks similar to what we saw following the 2008 crisis. We may eventually see liquidity-injection programs so extreme that hyperinflation becomes a valid concern. But that time is not now.

For now, we recommend getting out of debt. Especially variable rate, non-self-liquidating debt (credit cards being a great example). As we’ve said many times, in periods of deflation, debt can be a stone-cold killer.

Be sure to have positioned your financial portfolio to take into account the risks to stocks/bonds/etc raised here. Read our primer on hedging. Read the Financial Capital chapter from our book Prosper! (we’ve made it available to read for free here). Talk with our endorsed financial adviser (again, free of charge) if you’re having difficulty finding a good one to discuss this topic with.

And to really understand what life will be like as interest rates turn from a tailwind into a headwind for the global economy, read this report we published earlier this year, when the markets first buckled in 2016.

In Part 2: Why This Next Crisis Will Be Worse Than 2008 we look at what is most likely to happen next, how bad things could potentially get, and what steps each of us can and should be taking now — in advance of the approaching rout — to position ourselves for safety (and for prosperity, too).

Click here to read Part 2 of this report (free executive summary, enrollment required for full access)