Valuations for Dummies Part 2

This post is continued from Valuation for Dummies

So in the first entry, I basically explained how to value a project, the value of a firm, the value of equity, or the value of a stock (which is just equity per share). I will go into more details in this entry about the WEIGHTED AVERAGE COST OF CAPITAL (WACC), or simply the Cost of Capital.

Companies need to raise money to undertake different projects or for plans of expansion. They can accomplish that through 2 main financial instruments: Equity and Debt. The capital they raise of course come at a cost, as no one will lend out money for free. That cost, which is an interest rate (which would be a percent) is the Weighted Average Cost of Capital (WACC).

The WACC, or the Cost of Capital, is the average of the (1) THE COST OF EQUITY, and (2) THE COST OF DEBT. It is a percent at which you are discounting all the cash flows by, because it is how much it will cost for the firm (or the project) to get capital. Basically, an interest rate for the company. To think of it, you can think of the credit card APR for a company. Obviously, it will be a lot lower than our individual APR we get on our American Express card, because banks and investors believe that a company can pay back its debt better than individuals. The more likely you are able to pay back your debt, the lower the interest on capital is. For you and me, we have our credit score.

For corporations, there is something called Beta, which reflects how risky the company is. The lower the Beta, or the less risky the company is, the lower rate they will have. This is reflected in the COST OF EQUITY.

Corporations also have a rating, given by a rating agency (which can be Moody's, S&P). It is very similar to our individual credit score, except they are rated on different scales. For example, investment grade S&P ratings range from AAA to BBB. Depending on what rating the company has, it will have a different cost of debt. Each rating has a corresponding spread, that you add to the risk free debt (which is usually the 10-year U.S. Government bond), to get an interst rate for the COST OF DEBT.

Using the Cost of Equity and Cost of Debt, you can get the Weighted Average Cost of Capital by take the weight of equity times the cost of equity, plus the weight of debt times the cost of debt. Sounds complicated, but it's simply just the weighted average. Once you get your WACC, you can discount your cashflows by this interest rate! Next, I'll probably go into how to get your free cash flows.