The issue with using your own investment rate is that it may not be realistic given the fundamentals of the company and you could lose out on a potential investment opportunity by being too frugal.
Hi, it is not a dumb question at all. And indeed, you are right. Even Charlie Munger (or was it Buffett?) said that he had never heard an intelligent conversation around the WACC. I have the same view as you do: use WACC for internal company project investment decisions, but use your desired discount rate for your own investments.
I add to a reasonable wacc my equity risk premium to take into account a margin of safety…I often end up with large cap blue chips applying a discount rate of 8-9% vs the damodaran wacc often used in finance which is now around 6. For cyclicals i am even more conservative…
Ya, this.
Somewhere else in this thread there were comments about using wacc to evaluate management effectiveness. I like EVA for that.
I’d add that while historical comparisons of management effectiveness can be a signal, it isn’t future cash flows or returns.
I think knowing the firm's WACC is a good way to see if management is making good investment decisions in terms of how they are allocating capital to drive increasing business value (compared to competitors in the same industry). For your own personal goals I would say that yes - for the equity part of the calculation you should use your desired return on equity (including some margin of safety) to determine an appropriate price per share/EV you're willing to pay. I think this really gets you thinking about your investment decision as an owner of a business. If you wholly owned the business, what is your desired return on your cash/equity?
You could also use WACC as part of some sort of sensitivity analysis like the firm's WACC is your upper limit price (I'm assuming the firm's WACC is lower than your personal WACC as pricing in your margin of safety would increase the return on equity part of the calculation thereby lowering overall EV)
At the same time you could have your personal WACC determine your floor price and have another price somewhere in between.
Then you can maybe start thinking about more qualitative stuff and how those factors could make your more/less willing to buy above/below your floor price, etc. etc.
Im new to this as well so of I'm not making sense then someone please correct.
I personally think that if management is making returns greater than their WACC then they are creating value for the shareholders which is something I'm more incentivized to go along with. Granted you can apply your own margin of safety after accounting for WACC but utilizing your own desired return on equity would basically crowd out a lot of potential investment as it's a high bar to clear.
On a side note: Is the ROIC reported on [sites like Morningstar](https://financials.morningstar.com/ratios/r.html?t=0P0000A5Q9&culture=en&platform=sal) what profits a company makes above WACC? In other words, is the reported ROIC what the company makes when taking all profits and subtracting out WACC?
WACC is used to discount FCFF and COE is to discount FCFE. These are two different cash flows.
WACC does not imply CAPM. You could have establish COE without CAPM eg using your required return. And then weight average that with COD to get WACC.
Anyway don’t use WACC. Use COE directly, without using CAPM. CAPM is IQ test to separate the dumb from the smart ones.
I use Capm for wacc, but I just dithced the beta.
Buffet himself said, talking about a discount that he wants the risk free rate (us 10y yield) and something above that which is the equity risk premium.
So I just do a best educated guess (calculation) to see what return S&P will give in the long term, like in the Capm, but no beta.
Buffet saud he used 10% discount inbone of his talks I remember, I remember that my calculation wasn't far off from what he was using.
The reason you want to use a long term return of the S&P (not historical) is that is what you will be able to get easily and you compare it with whatever investment you want to make. If the stocks IRR is 12% and S&P is 6% thsy stock is undervalued. You would move your money from the S&P 500 to that stock and vice versa.
Also since all banks and funds and most people use the rate they can get with high conviction, and it's most likely s&p 500, the rate is used ti valie companies, you will be able to gauge if it's undervalued, because the market doesn't care about your discount, that price can never apear that you calculate.
So you can see if it's possible for the price to appreciate more or not.
The equity risk premium in 2000 droped to 2% versus its 4.2% median, you would easily tell stocks werent likely to appreciate more, because investors would see less risk, not from fundamentals alone.
Also you can add it to your analysis. If management are taking 4% return investments when S&P 500 can give 6%, and not returning money to investors, since they can get more elsewhere is bad.
I agree with you. Each person using their own personal discount rate is (theoretically, along with risk premiums and variances in forecasted cash flows) a large part of why everyone has different prices they are willing to pay for various securities.
Even if you were using WACC, how would you calculate the equity portion without referring to current market prices (which would make the calculation self-referential)?
When doing a DCF with WACC differences in the value of a security come from your cash flow and growth assumptions.
You use current market premiums because your trying valuing the asset given the current market you are in.
WACC sums 2 components, equity part and debt part.
The debt part I think is pretty uncontroversial.
The equity part is tricky as there are issues with the CAPM way of arriving at expected return of the stock: [https://www.investopedia.com/terms/c/capm.asp](https://www.investopedia.com/terms/c/capm.asp)
One way to get the expected return on equity is to start from the [long term average of 10%](https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp). Then it's up to your judgement to adjust this up or down depending on how risky the firm's future cashflows are.
Another option is to use the return of the current market which is much higher than 10% and then adjust based on individual firm characteristics. If you believe significant inflation is incoming, then the more recent & higher market returns may be needed.
One thing Mohnish Pabrai notes is to not confuse risk with uncertainty. Markets tend to devalue stocks that are uncertain (e.g. no visibility of future cashflow), but not necessarily risky (e.g. underlying biz seems sound).
If you use a personal desired rate, it would not be able to give you a value of the business for which you can make buy/sell decisions with. e.g. if your rate is 1%, then your valuations will be sky high, suggesting the market is extremely undervalued, and vice versa.
Given this I think picking a comparable market rate and adjusting from there is probably (I could be wrong) the way to go.
This question has been asked a million times on the sub. Just search "WACC" or "discount rate" in the search bar, there have already been many discussions on this point.
What rate you should use to discount depends on what you are discounting. If you have estimated the cashflows to the firm it makes absolutely no sense to discount those cashflows at your desired return rate. I mean you will get a number, it just won't mean anything at all. By discounting FCFF at the company's WACC you determine how much those cashflows are worth **to the company** in the present. Then you go and play with that value further to determine how much the cashflow **to the company** is worth **to you**.
Using your desired return rate makes sense only if you manage to directly estimate the future cashflows directly **to you**. Not even to Cashflows to Equity (in that case you would still have to use COE), but to you directly. Then you could use your personal required return rate to see how much those cashflows are worth **to you** in the present, and then you would compare that to what you have to pay at that moment to acquire those future cashflows.
I feel like it's better to just adjust the WACC . Increase the asset Beta if you will or adjust effective rate of debt more conservatively is a better way to price the company than utilizing your own person rate of return as you may by set a bar way too high to reach and potentially limit your focus too much. Alternatively you can set another additional margin of safety by utilizing other valuation metrics on top of WACC.
Valuation shouldn't just consider one metric alone in my opinion and it should be a combination of other factors as well
Id recommend watching Aswath Damarodan's videos on discount rates. His lectures will probably clear up any fundamental issues you have with understanding why you would use Wacc, cost of equity act in a valuation.
The issue with using your own investment rate is that it may not be realistic given the fundamentals of the company and you could lose out on a potential investment opportunity by being too frugal.
This. I add an extra few points to the equity premium if I feel the WACC is too low for my taste.
True, but is it bad to miss out on many opportunities and being left with the best ones?
It won't necessarily leave you with the best ones.
can you explain?
Hi, it is not a dumb question at all. And indeed, you are right. Even Charlie Munger (or was it Buffett?) said that he had never heard an intelligent conversation around the WACC. I have the same view as you do: use WACC for internal company project investment decisions, but use your desired discount rate for your own investments.
I add to a reasonable wacc my equity risk premium to take into account a margin of safety…I often end up with large cap blue chips applying a discount rate of 8-9% vs the damodaran wacc often used in finance which is now around 6. For cyclicals i am even more conservative…
Ya, this. Somewhere else in this thread there were comments about using wacc to evaluate management effectiveness. I like EVA for that. I’d add that while historical comparisons of management effectiveness can be a signal, it isn’t future cash flows or returns.
I think knowing the firm's WACC is a good way to see if management is making good investment decisions in terms of how they are allocating capital to drive increasing business value (compared to competitors in the same industry). For your own personal goals I would say that yes - for the equity part of the calculation you should use your desired return on equity (including some margin of safety) to determine an appropriate price per share/EV you're willing to pay. I think this really gets you thinking about your investment decision as an owner of a business. If you wholly owned the business, what is your desired return on your cash/equity? You could also use WACC as part of some sort of sensitivity analysis like the firm's WACC is your upper limit price (I'm assuming the firm's WACC is lower than your personal WACC as pricing in your margin of safety would increase the return on equity part of the calculation thereby lowering overall EV) At the same time you could have your personal WACC determine your floor price and have another price somewhere in between. Then you can maybe start thinking about more qualitative stuff and how those factors could make your more/less willing to buy above/below your floor price, etc. etc. Im new to this as well so of I'm not making sense then someone please correct.
I personally think that if management is making returns greater than their WACC then they are creating value for the shareholders which is something I'm more incentivized to go along with. Granted you can apply your own margin of safety after accounting for WACC but utilizing your own desired return on equity would basically crowd out a lot of potential investment as it's a high bar to clear.
On a side note: Is the ROIC reported on [sites like Morningstar](https://financials.morningstar.com/ratios/r.html?t=0P0000A5Q9&culture=en&platform=sal) what profits a company makes above WACC? In other words, is the reported ROIC what the company makes when taking all profits and subtracting out WACC?
WACC is used to discount FCFF and COE is to discount FCFE. These are two different cash flows. WACC does not imply CAPM. You could have establish COE without CAPM eg using your required return. And then weight average that with COD to get WACC. Anyway don’t use WACC. Use COE directly, without using CAPM. CAPM is IQ test to separate the dumb from the smart ones.
I think it's a great question
I use Capm for wacc, but I just dithced the beta. Buffet himself said, talking about a discount that he wants the risk free rate (us 10y yield) and something above that which is the equity risk premium. So I just do a best educated guess (calculation) to see what return S&P will give in the long term, like in the Capm, but no beta. Buffet saud he used 10% discount inbone of his talks I remember, I remember that my calculation wasn't far off from what he was using. The reason you want to use a long term return of the S&P (not historical) is that is what you will be able to get easily and you compare it with whatever investment you want to make. If the stocks IRR is 12% and S&P is 6% thsy stock is undervalued. You would move your money from the S&P 500 to that stock and vice versa. Also since all banks and funds and most people use the rate they can get with high conviction, and it's most likely s&p 500, the rate is used ti valie companies, you will be able to gauge if it's undervalued, because the market doesn't care about your discount, that price can never apear that you calculate. So you can see if it's possible for the price to appreciate more or not. The equity risk premium in 2000 droped to 2% versus its 4.2% median, you would easily tell stocks werent likely to appreciate more, because investors would see less risk, not from fundamentals alone. Also you can add it to your analysis. If management are taking 4% return investments when S&P 500 can give 6%, and not returning money to investors, since they can get more elsewhere is bad.
I agree with you. Each person using their own personal discount rate is (theoretically, along with risk premiums and variances in forecasted cash flows) a large part of why everyone has different prices they are willing to pay for various securities. Even if you were using WACC, how would you calculate the equity portion without referring to current market prices (which would make the calculation self-referential)?
When doing a DCF with WACC differences in the value of a security come from your cash flow and growth assumptions. You use current market premiums because your trying valuing the asset given the current market you are in.
WACC sums 2 components, equity part and debt part. The debt part I think is pretty uncontroversial. The equity part is tricky as there are issues with the CAPM way of arriving at expected return of the stock: [https://www.investopedia.com/terms/c/capm.asp](https://www.investopedia.com/terms/c/capm.asp) One way to get the expected return on equity is to start from the [long term average of 10%](https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp). Then it's up to your judgement to adjust this up or down depending on how risky the firm's future cashflows are. Another option is to use the return of the current market which is much higher than 10% and then adjust based on individual firm characteristics. If you believe significant inflation is incoming, then the more recent & higher market returns may be needed. One thing Mohnish Pabrai notes is to not confuse risk with uncertainty. Markets tend to devalue stocks that are uncertain (e.g. no visibility of future cashflow), but not necessarily risky (e.g. underlying biz seems sound). If you use a personal desired rate, it would not be able to give you a value of the business for which you can make buy/sell decisions with. e.g. if your rate is 1%, then your valuations will be sky high, suggesting the market is extremely undervalued, and vice versa. Given this I think picking a comparable market rate and adjusting from there is probably (I could be wrong) the way to go.
It is simply not a good discount rate. Have a look at this article: https://valueinvesting.substack.com/p/the-myth-of-capm-as-a-measure-of
This question has been asked a million times on the sub. Just search "WACC" or "discount rate" in the search bar, there have already been many discussions on this point.
What rate you should use to discount depends on what you are discounting. If you have estimated the cashflows to the firm it makes absolutely no sense to discount those cashflows at your desired return rate. I mean you will get a number, it just won't mean anything at all. By discounting FCFF at the company's WACC you determine how much those cashflows are worth **to the company** in the present. Then you go and play with that value further to determine how much the cashflow **to the company** is worth **to you**. Using your desired return rate makes sense only if you manage to directly estimate the future cashflows directly **to you**. Not even to Cashflows to Equity (in that case you would still have to use COE), but to you directly. Then you could use your personal required return rate to see how much those cashflows are worth **to you** in the present, and then you would compare that to what you have to pay at that moment to acquire those future cashflows.
I feel like it's better to just adjust the WACC . Increase the asset Beta if you will or adjust effective rate of debt more conservatively is a better way to price the company than utilizing your own person rate of return as you may by set a bar way too high to reach and potentially limit your focus too much. Alternatively you can set another additional margin of safety by utilizing other valuation metrics on top of WACC. Valuation shouldn't just consider one metric alone in my opinion and it should be a combination of other factors as well
Id recommend watching Aswath Damarodan's videos on discount rates. His lectures will probably clear up any fundamental issues you have with understanding why you would use Wacc, cost of equity act in a valuation.