Denice R. Preston
The discount rate plays a crucial role in discounted cash flow analysis. How can an analyst determine a reasonable discounted rate for a company with no publicly traded equity or debt?
This article discusses best practices in estimating the WACC within the context of private company valuation. The discussion starts with an overview of WACC. It then moves on to the background of WACC components, the methods of estimating the WACC components, and finally, an example of applying this framework to a privately held building materials company.
Today, a growing number of companies choose to remain private longer and bypass regulations. They also avoid public stakeholders. The number of US-listed companies has declined 45% from its peak 20 years ago. Reported in 2017 that the number of publicly traded companies had dropped from 7,322 to 3,671. Private company valuation is now a hot topic, as it’s required for everything from corporate restructuring to potential acquisitions. Both personal business owners/operators, as well as investors/valuation experts, need to understand how discount rates and their role are calculated. Private Company Valuation is often lacking publicly available data. Both types of valuation share a common feature: the use of discounted cash flow analysis ( DCF), which requires both an estimation of future cash flows and a discount rate.
This article is based on my twelve years of experience in private company valuations and on various editions of The Cost of Capital: Examples and Applications. The discussion starts with an overview of the DCF and WACC. A detailed explanation of each component of the WACC follows this. This article will not only cover WACC in the CFA and accounting programs but also show how to handle challenges in practice best. It’s not surprising that many classroom rules don’t work in the real world. Since variables used to estimate WACC cannot be pulled directly from a database but rather require analysis and judgment, this is a complex process.
How to build a discounted cash flow (DCF) analysis
Estimating the present value for expected cash flows relating to assets, projects, or businesses is perhaps the most fundamental and widely used concept in corporate finance. The DCF analysis involves the following steps.
Calculating a discount rate by taking into account the time value and relative riskiness associated with the cash flows.
Calculate the present value of estimated cash flows in each year of the projection period by using the estimated discount rates.
Estimating the terminal value of the cash flows expected beyond the projected period.
The second step will be the focus of this article. Consider the following to illustrate the relationship between the expected cash flow and discount rate. A US Treasury bond, which is highly predictable and virtually risk-free, requires a low discount rate. A technology company with a more volatile cash flow in the future would need a higher rate of discount. Risk can be taken into account by adjusting cash flow expectations, but the most common method is to increase the estimated discount rate.
An extensive analysis is required to support the discount rate used in a DCF calculation. Incorrect discount rates can lead to a poor investment or the omission of an opportunity that could create value.
Calculating Discount Rates Using Weighted Average Capital Cost (WACC)
The WACC must be included in a DCF evaluation. A company’s capital is divided into two main categories: debt and equity. The WACC is a weighted average return required by these two sources of capital. The discount rate should match the intended beneficiaries of the projected cash flow in the DCF. If the projected cash flows are for all capital owners, then the WACC would be the appropriate rate. If cash flows are projected for equity holders, then the cost of equity should be used as the discount rate.
The WACC is not only a crucial input in a business appraisal, but it also provides a comparison between the return on investment capital (ROIC). If the ROIC is higher than the WACC, a company will grow and create value. However, if it falls below the WACC, then the value of the business will be destroyed. The management can use this analysis to focus on growth or profitability to increase Enterprise Value.
The WACC Formula
The required return for each funding source is multiplied mathematically by the weight of that source in the capital structure of the company. The WACC is the sum of all the weighted components. The formula for WACC can be found as follows:
The WACC formula may be simple, but a lack of transparency makes estimating inputs for private companies more difficult. I will explain how to calculate each of the components of the formula in the sections that follow, beginning with the debt and equity costs and their weights. In the rest of this article, we’ll use a company as a model (Company XYZ) to show how to estimate each component of a WACC for private companies.
Examples of Company Background
Below is a table that contains some background information for estimating discount rates. Due to the subjective nature, there’s a lack of precision when calculating discount rates. It is, therefore, common practice to estimate an estimated range of discount rates.
Please note that Company XYZ has its headquarters in the United States, and all revenues and profits are denominated in US dollars. The discount rate is based on US inputs. The discount rate must be estimated in the currency of the cash flow (i.e., if cash flows are calculated using a foreign currency, the discount rate inputs should also come from that country).
Cost of Debt
The cost of debt refers to the interest rate a company pays for its long-term bonds. This is usually based on yield-to-maturity, the expected return on an investment if it is held to maturity. The YTM is not available for private companies, but it can be viewed in terms of the interest rate a prudent investor would demand on similar long-term debt. Before examining sources of the pretax debt cost, it is important to estimate the credit rating of the company.
Two credit rating agencies rate public companies: Moody and S&P. These agencies conduct due diligence on the financial condition of the borrower company and their ability to service the debt. Their rating systems can be divided between investment grade and speculative/non-investment grade, with a spectrum of ratings within each category. The table below summarizes each rating agency’s system.
