The concept of a discounted cash flow analysis is simple: we forecast the company’s free cash flows and then discount them to the present value using the company’s weighted-average cost of capital (WACC). Calculating WACC, however, can be a bit more complicated. Let’s take a closer look at how it is done.
The weighted average cost of capital or WACC represents weighted average price a company must pay for debt or equity capital. The formula for WACC is straightforward:
WACC = Cost of Debt * Debt / (Debt + Equity) + Cost of Equity * Equity / (Debt + Equity)
The weightings of capital in this equation are very easy to calculate based on the company’s current balance sheet. The cost of debt is a little more involved, but pretty straightforward, but the cost of equity calculation can be difficult.
For a company with publicly traded debt, you would need to look up the current yield to maturity for each piece of debt that it has outstanding. You would also need to look at the rate paid on each piece private debt on the company’s balance sheet. You then take the weighted average of all these yields and rates to come up with company’s cost of debt.
Cost of Equity
The cost of equity in a WACC computation can be represented by the capital asset pricing model (CAPM):
Ke = Rf + Beta (market risk premium) + (other company-specific premiums)
In this equation, Ke is the cost of equity and Beta is a measure of how the value of a company moves with respect to the value of the overall market. The market risk premium is the premium that investors demand to invest in the stock market versus the U.S. treasury market. Other premiums might include a “small cap premium” or a “private company premium.”
The market risk premium as well as other premiums are often taken from a source such as Ibbotson. In general the market risk premium is usually somewhere between 7 and 8%. The risk free rate is usually assumed to be a medium-term U.S. treasury yield (1-10 years).
Once you have pulled together these variables – many of which are available from sources such as Bloomberg or Yahoo Finance – you plug them into the CAPM formula to calculate the cost of equity. You can then plug the cost of equity into the WACC formula, and you now have a weighted-average cost of capital for a discounted cash flow analysis.