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From the standpoint of an investor: why use WACC for company valuation?

Thomas Michael's Profile

I've recently been in a dicussion and could not give an honest explanation to the following question:
Why is the value of a company determined by discounting its cashflows with the WACC?

This sound obvious at first, but hear me out:

The WACC is the cost of capital and thus the return of capital givers. If an investor were to buy all outstanding shares and debt, the WACC would be his return percisely. So far, so good.

An investor now forecasts the cashflows of the business and discounts them with that WACC - why?
I understand that an investor includes the cost of capital in his interest rate, but at the same time the investor is a benificiary of that same cost of capital. Therefore, discounting future cashflows with the WACC gives a price that, if paid, will grant the investor whatever return is taken as a basis to calculate the WACC. If that price is higher/lower than the current market price, it only tells me that the market and the investor have differing forecasts for future cashflows - nothing more. If I wanted to know the price of the company, I could simply takes its market cap and the market value of its debt as that is its actual price - no need for fancy DCM calculations.

In summary: why do we discount the forecastet cashflows of a business with its WACC when:
a) the company value is determined by current market prices
b) the difference between discounted value and prevailing market price only tells the investor that his and the market's forecasts differ

I hope my thoughts and the question are comprehensible. Would be really glad for any advice!

Answers

Topic Expert
Jake Feldman
Title: Managing Director
Company: Global TaxFin Advisory Group LLC
(Managing Director, Global TaxFin Advisory Group LLC) |

Quite right, read some of Damodaran's writings on price vs. value. So, if you managed to find your favorite brand item deeply discounted somewhere, is that the price or value of the item?

Mark Sutherland
Title: CFO
Company: Profit By Design CFO & Controller Servic..
(CFO, Profit By Design CFO & Controller Services) |

I've done valuations for my clients who are either looking at an acquisition target, considering selling their company, or simply want to monitor (annually) the value of their enterprise. I don't have my reference materials at hand presently, but I believe the model we were using was called the "Modified Capital Asset Pricing Model" (MCAPM), specifically the "Single Period Capitalization Method" (the multi-period method can also be used). The formula looks like this:
PV=[Net Free Cash Flow X (1+g)] / (d-g), where

d=discount rate (your WACC)
g=expected growth rate of NFCF

The "d" value, or the required return value is comprised of:
>Risk-free rate
>Equity risk premium
>Company size premium
>Specific company risk premium

I built my "d" factor using Ibbotson as my main resource (I believe Ibbotson is now owned by S&P?). It is clear to me that different people/entities will arrive at different prices based on their perception of 1)growth prospects and sustainability of same, and 2)perceived risk. Any changes in the "g" factor or the risk premium factors can make a dramatic difference in calculated value/price.

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