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WACC - Parameter guidance

The Importance of WACC

WACC (Weighted Average Cost of Capital) is a key component when DCF fair value is calculated. Even small changes in WACC may cause significant change in DCF. WACC alone is not that important - nobody makes investment decisions based purely on WACC. To some extent you can even modify WACC-parameters to justify your own fair value with DCF. Still remember that this can be done only after you have done reality check with DCF that has not been modified.

WACC - Parameters

How should you set WACC-parameters? Here are some tips how it should be done:
 
Tax rate. Simply fill out your company's tax rate. Basically this is your company's home country's tax rate for companies. In Finland the tax rate is due to decrease to 26 % (from 29 %).
 
Target debt ratio (D/D+E). In many cases company has stated their target debt ratio. If your company hasn't, you can think what it could be. Try to stay away from extremes. Depending on company, the debt ratio is normally around 5-60 %. Do not confuse actual debt ratio for the target debt ratio. They are usually two completely different things, but we prefer to calculate WACC with long-term target instead of volatile actual values.
 
Cost of debt. Try to estimate what is the cost of debt of your company. Cost of debt varies according to company and economical situation. Try to estimate your company's cost of debt, if company doesn't tell it or it can not be reliably calculated from financial statements (sometimes the company includes such items in interest expences etc. that the calculated values do not tell the whole truth). This such as size, financial situation, profitability and possible credit rating affect the value. Normally cost of debt is about 0.25% - 1.5%-points more than risk free interest rate (for small/unprofitable companies somewhat more than with blue chips). If you have not better way to estimate the value, then you can e.g. assume that it is 0.75%-points more than long-term risk-free interest rate - and it probably is not very far away from truth. So if risk-free rate is 5%, then let cost of debt be 5.75%.
 
Equity beta. Describes what is the relative equity risk concerning your company (normally the risk of its business sector). The average beta is 1 and thus the companies that have about average risk have beta of 1. If the business is more risky (very cyclical, high fixed costs/operational leverage) then the beta is more than 1 (normally 1.1 - 1.5). This kind of businesses are e.g. internet business (high fixed costs, high operational risk), pulp and paper (cyclical and high fixed costs). If the business is less risky (very smooth: not cyclical and not very high operational risk) then the beta is below 1 (normally 0.6 - 0.9). This kind of businesses are real estate and food and beverage retail and production. We have made a table that has different betas for different businesses and it can be found right after this text. There’s also other information about equity beta and its estimation. Normally you get biased betas if you estimate them from market data from illiquid companies or illiquid /not-so-diversified markets. Therefore it is normally better to estimate the beta yourself than to get it from market data. You can estimate them by assessing whether the company is more or less risky than some other industries whose beta you know.
 
Market risk premium. It describes the premium that equity investors tend to expect to get when investing to equity markets compared to return they would get from risk-free investments - long-term government bonds. Normally equity research producers use hereby values between 3.5% - 5%, even though some academic research has suggested also that the premium might be as big as 6%. The problem is that there is no method to get/estimate the value in reality, so we just have to take some reasonable value here. It would also be important that the value would be about the same with every analyst and currently we recommend that this value would be 4.75; So use it until you hear otherwise.
 
Liquidity premium. It is introduced to WACC calculation to explain a difference between two types of financial securities, that have all the same qualities except liquidity. The extra return is demanded as a compensation for holding assets that may be difficult to convert into cash.

Risk free interest rate. Input the interest rate of government 10 year bond. For example Finland's government bond it is currently about 4,3 %. You should use the one of your country/your own currency area. The risk free interest rates varies a bit in different currency areas as the long-term interest rate holds inside the expectation about the future inflation. As the real interest rate (interest what people expect to get from risk free investments after inflation has been deducted) is about 3%, then the long-term risk free interest rate is currently: real interest rate + current long-term inflation expectation = 3% + 1.3% = 4.3%

Equity Beta

What is beta and what does it indicate?

Beta measures the risk of the company (and its stock) relative to the risk of the stock market in general - how risky is the type of business the firm does and how risky is the financial structure or leverage of the firm. With greater risk, as measured by a larger variability of returns (business or operating risk), the company's should have a larger beta. And with greater leverage (higher debt to value ratio) increasing financial risk, the company's stock should also have a larger beta.
With a larger beta, an investor should expect a greater return. The beta of an average risk firm in the stock market is 1.00. Normally betas vary between 0,60 - 1,30, although they also can be much higher or lower.

Beta values of some businesses

These values are for your guidance, but they are not valid as they are. They should give you some direction of what could your company's beta be. You might want to use them as a starting point - after that you can consider other significant factors and modify your company's beta from that of subjective industry. Other important components that should be considered when "fine tuning" beta of your company can be found from the following chapter, beta and risk components.

Business sector                             
Beta
 Unlevered beta
 Internet
 1,51  1,50
 Semiconductor
  1,34  1,31
 Telecom equipment  1,21  1,17
 Computer software & services  1,20  1,20
 Air transport  1,10  0,83
 Drug  1,06  1,04
 Retail store  1,05  0,95
 Furniture, home  0,90  0,82
 Railroad  0,87
 0,65
 Textile   
 0,82  0,49
 Beverage   
 0,80  0,73
 Food wholesale  0,80
 0,66
 Tobacco  0,75  0,68
 Real Estate  0,74  0,69
 Food processing  0,72  0,63
 Electric utility  0,60  0,40

Beta and risk components

The following list has some components you might want to consider when you estimate beta of your company. The weight of each component is set to be 20 % - this is just one way to look at risks / beta, not the only or necessary correct way. The most important thing in this table that you recognize also these factors.

Some risk components to think about (weight):

Financial leverage
  20 %
Size  20 %
Valuation  20 %
Subjective Industry / Business  20 %
Subjective Company  20 %