In our previous letters, we introduced two essential metrics for assessing a business's quality: profitability and capital efficiency. However, one final piece is needed to determine whether a company is truly creating value for its shareholders: cost of capital. 

Consider this analogy: If individuals borrow money at an interest rate of 4% per year and invest it at a return of 8% per year, they become wealthier. However, if their return is only 2%, they lose money. The same principle applies to companies. A business that earns a return above its cost of capital generates value for its shareholders, while one that earns below its cost of capital destroys value. 

To evaluate this, we need to look at how a company funds its business operations, which means to look at its capital structure. Capital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. A firm’s capital structure is typically expressed as a debt-to-equity or debt-to-capital ratio. 

Debt and equity capital are used to fund a business’s operations, capital expenditures, acquisitions, and other investments. There are tradeoffs firms have to make when they decide whether to use debt or equity to finance operations, and managers will balance the two to find the optimal capital structure. It is then important to understand a company’s cost of capital, which is where the Weighted Average Cost of Capital (WACC) comes into play; ultimately the optimal capital structure of a firm is often defined as the proportion of debt and equity that results in the lowest weighted average cost of capital (WACC). 

Introducing WACC: The Cost of Capital

The Weighted Average Cost of Capital (WACC) is a critical financial metric that represents the average rate of return a company must pay to its investors for using their capital. It reflects the cost of both equity and debt financing, weighted by their respective proportions in the company’s capital structure. WACC serves as a benchmark for evaluating whether a company is generating sufficient returns to cover its cost of capital and create value for shareholders.

We calculate WACC as:

Where:

E = Market value of equity

D = Market value of debt

Cost of Equity = Required return on equity

Cost of Debt = Interest rate on the company’s debt

Tax Rate = Corporate tax rate

While the formula might seem intimidating, the above can be translated in three simple steps:

1. Multiply the cost of equity by the proportion of equity in the capital structure.

2. Multiply the cost of debt by the proportion of debt in the capital structure, then adjust for the tax shield.

3. Add the two results together to get WACC

The cost of equity represents the return required by investors for holding the company’s stock. In simple terms, it’s the “price” a company pays to use shareholders' money. Since investors take a risk by investing in the company, they expect to earn a return either through dividends or stock price appreciation. Unlike debt, which has a fixed interest rate, equity does not have an explicit cost that the company must pay. Instead, companies estimate the cost of equity using sophisticated models like the popular Capital Asset Pricing Model (CAPM). Both Antonio and I prefer a simpler approach and see the cost of equity as the opportunity cost of shareholders' capital. If the long-term average return of the stock market is 10% per year, then earning less than 10% would seem inappropriate. So, sticking to at least 10% as the cost of equity is a good rule of thumb. After all, it’s better to be approximately right than precisely wrong! If the company fails to deliver this expected return, shareholders may sell their shares, leading to a decline in both share price and the company’s value.

The cost of debt is much more straightforward than the cost of equity: it is simply the interest that companies pay on their debt. For the most part, companies take on debt by selling corporate bonds, but they may also have other types of debt, such as bank loans and revolvers. Usually, they have a mix of short-term and long-term debt in their capital structure, which must be accounted for. Long-term debt is usually more expensive than short-term debt because of the greater uncertainty associated with longer periods of time. Interest payments on debt are tax-deductible, which reduces the company’s taxable income, so the cost of debt must be adjusted by multiplying it by (1 – tax rate) to reflect the tax shield and avoid overstating the true cost. This tax benefit effectively lowers the after-tax cost of debt, making debt financing cheaper than it would otherwise be.

WACC is a crucial metric because it represents the minimum return a company must earn on its investments to satisfy its investors and lenders. If a company’s return on capital is lower than its WACC, it is effectively destroying value, as it is not generating enough returns to cover the cost of its capital. Conversely, if a company’s return on capital exceeds its WACC, it is creating value for its shareholders.

Example

Let’s consider a hypothetical company called “MyCo” and suppose its market capitalization (or the market value of its equity) is $4 million, and  the market value of the company's debt is $1 million.

Let's further assume that MyCo's cost of equity, the minimum return that shareholders demand, is 10%. Thus, the weight E/(E+D) would equal 0.8 ($4,000,000 of equity value divided by $5,000,000 of total financing).  Therefore, the weighted cost of equity = 0.8 × 10% = 8%. This is the first half of the WACC equation.

Now we have to figure out MyCo's weighted cost of debt. To do this, we need to determine the weight D/(E+D); in this case, that's 0.2 ($1,000,000 in debt divided by $5,000,000 in total capital). Next, we would multiply that figure by the company's cost of debt, which we shall say is 5%. Last, we multiply the product of those two numbers by 1 minus the tax rate. If the tax rate is 25%, then 1-25%=75%  Therefore:

Weighted cost of debt = (0.2 × 5%) x 75% = 0.75%

Adding those two numbers together gives the weighted average cost of capital:

WACC = 8% + 0.75% = 8.75%

This value represents MyCo’s average cost to attract investors and the return they expect, given the company’s financial strength and risk compared to other investment opportunities. You can now easily see that if MyCo invests in a new project that generates a 12% return, it will create value for shareholders. However, if the return is only 6%, the project will destroy value, as it fails to cover the cost of capital.

Limitation of WACC

The Weighted Average Cost of Capital (WACC) is an important financial financial metric used to determine the minimum return a company must generate to satisfy its investors. However, it has several limitations that can affect its reliability and applicability in real-world scenarios:

1. Assumes Constant Capital Structure: WACC assumes that a company's capital structure remains constant over time. In reality, companies often change their capital structure by raising new capital, retiring debt, or issuing equity. This assumption can lead to inaccuracies in the calculated cost of capital, as the actual cost may vary significantly over time

2. Ignores Risk Variability: WACC does not differentiate between projects with varying risk levels. It is based on the overall risk profile of the company, which may not accurately reflect the risks associated with specific investments. This can result in poor investment decisions when evaluating high-risk projects using a uniform WACC.

3. Sensitive to Input Variability: Calculating WACC involves several inputs, such as interest rates, which can fluctuate significantly. This variability can lead to inconsistent results, making it challenging to rely on WACC as a stable measure of capital costs.

4. Sector-Specific Challenges: Different industries have distinct risk profiles and capital structures. Applying a uniform formula across various sectors may not yield accurate results, as companies in different industries may face unique financial challenges and opportunities, which is usually reflected in different ROCE / ROIC / ROC.

The above mentioned reasons bring us to the conclusion that, while it is important to calculate the WACC to better understand the capital structure of a company, to have some margin of safety we usually like ROIC > 15% and ROCE / ROC > 20% as we mentioned in Profitability - Part II.

Conclusions

The pursuit of high earnings rates on equity capital employed, as emphasized in Part I and Part II, must be complemented by a rigorous analysis of capital efficiency and a thorough understanding of WACC. By focusing on these metrics, investors and managers can identify companies that are not only profitable and efficient in their use of capital but also capable of generating returns that exceed the cost of capital.

The ultimate test of managerial economic performance lies in the ability to create sustainable value for investors. This requires a disciplined approach to capital allocation, a focus on generating high returns on capital, and a commitment to minimizing the cost of capital. By adhering to these principles, businesses can ensure long-term success and create a legacy of value for generations to come. The understanding of the relationship between ROCE / ROIC / ROC and WACC is the final and most important step to understand if a company is truly adding value, and not simply growing.

Putting together all we have learned in the past few weeks, we can see how all fits together. The combination of growth and profitability measured by return on invested capital relative to its cost is what drives value; the faster companies can increase revenues and deploy more capital at attractive rates of return, the more value they create.

Finally, value creation has to withstand competition and be durable, so a company must have or build what Warren Buffet calls “Moat”...but this will be for a next episode.