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IN RESPONSE TO THE MANY LENGTHY BOOKS THAT HAVE BEEN WRITTEN ABOUT COMPANY VALUATION, HERE IS A SHORTCUT TO COMPANY VALUATION APPLYING THE WACC METHOD.
Under the weighted average cost of capital (WACC) method, the value of a company is determined by discounting expected income streams with the company's cost of capital (or WACC). This article explains the WACC method using simple quantitative examples and a case study based on a real-life supermarket chain.
The Basics (Without Corporate Taxes)
The value of an enterprise is generally understood as the equity value (E) plus the value of the interest-bearing debt (i.e., the debt capital) (D). If, for example, equity is $10 million and the enterprise has $3 million in debt capital, the enterprise value is $13 million. The WACC method yields this total enterprise value, in this case $13 million, as a result. To determine the equity value of this enterprise value, one must subtract the value of the debt capital from the total enterprise value.
In this article, the term "value" does not represent the book value as found on a balance sheet, because that number is (often) based on historical costs; the value that is found using the WACC method usually deviates from that value. In general, if one can earn more with the assets of an enterprise than the assets cost, the calculated value will be higher than the book value. This calculated value is also called the market value.1
How does the WACC method work? When applying the WACC method, one must first determine the expected free cash flows (FCFs). FCFs are cash flows that could be paid by the enterprise to the providers of capital after all the desired investments and divestments have been made. The providers of equity and debt are the providers of capital. Subsequently, these FCFs are turned into present values using the enterprise WACC. The WACC is the weighted average of the required return of the providers of equity and debt. For example, if the shareholders of a 50% leveraged firm (i.e., 50% debt and 50% equity) require a return of 14%, and the holders of debt require a 6% return, the WACC of this firm is 10%.
Example 1. Enterprise "Salt" is expected to...