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A Few Reasons Why WACC Is Flawed

In its simplest terms WACC stands for Weighted Average Cost of Capital and is used to measure how much it costs for a company to acquire capital (through a mixture of debt and equity). Once you have found this number you theoretically have a nice discount rate in figuring out the present value of a company's cashflow. The problem is any slight change in the WACC will have vast implications on your investment decisions. For example, setting your WACC 1% higher or lower can mean the difference between a buy or a no-buy on a stock.

What does the WACC formula look like?

Immediately we start to see some problems.

1. The Tax Shield

Let's say you had a company with a 10% cost of equity and 10% cost of debt. The WACC would not be 10% as the debt portion of the equation is shielded from tax, making debt much cheaper than equity. This causes many problems... The first of which is that the more debt a company has, the better their cost of capital will be due to this tax shield. A company with very high debt may sometimes have a very low WACC for this reason, and it ultimately results in a high valuation for the company's shares.

Wait a minute... More debt equals a less risky investment therefore a higher valuation? As a value investor I have a major problem with this. In a formula that is supposed to dictate risk levels we are encouraging debt instead of discouraging debt. It can definitely be argued that companies with less debt perform much better than their levered peers in the long-term and we are doing the exact opposite here in using WACC.

2. The Beta Problem

In order to calculate a firm's Cost of Equity in the WACC formula you must first calculate their 'beta'. Beta is supposed to be a measure of risk by comparing the stock's volatility to the entire market. The volatility of the S&P 500 is usually used as the base and is given a 'beta' of one. Any stock with a beta above one is said to be more volatile, and therefore more risky, and a stock with less than one is less risky.

As a value investor I believe this to be very, very flawed. Volatility is simply not risk. By measuring risk this way we are saying that a company which has absolutely brutal financials but has a non-volatile stock price could be less risky than a volatile stock with a rock solid balance sheet and cashflow.

One of my value investing friends and I were joking about this matter recently. My friend has a portfolio comprising of 80% cash and 20% equities which are quite volatile (value stocks). In this portfolio it is important to note that the most my friend could ever lose is 20% of his money. However, when looking at the beta of his portfolio it was quite high. This implies that someone with 100% of their money in an index fund (who could theoretically lose 100% of their investment) has a safer portfolio than my friend, even though there is no possible way for him to lose more than 20% of his capital.

What Warren Buffett Uses

Warren Buffett, the genius behind Berkshire (NYSE:BRK.A) (NYSE:BRK.B), seems to contradict himself often when talking about WACC and what rate to use in discounting cashflows. After studying this issue I think I have deciphered what he actually does.

Let's take a look at his quotes on the matter:

In his 1998 Annual Meeting:

"We don't discount the future cash flows at 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can't compensate for risk by using a high discount rate."

The US Treasury? Right now those are about 2.5% which could give you a very high valuation on a company. I like Buffett's thinking here of avoiding any subjective variables, but how could it apply in an economy like today's? One way around this is issue is to use a spread such as the historical average of government interest rates which would give you 6.59% since 1962. This brings us to more subjectivity- what time periods should you use?

Here is another comment from his 2003 Annual Meeting:

"The trouble isn't that we don't have one [a hurdle rate] - we sort of do - but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I'd reject it instantly. Everything is a function of opportunity cost."

This quote brings us closer to what I believe Buffett actually uses. Buffett views everything as an opportunity and he will use an extremely high rate to screen bad investment until only the most undervalued companies are left. He explains this further in the quote below:

"[When investing] you do not it cut close. That is what Benjamin
Graham meant by having a margin of safety. You don't try and buy
a business worth $83 million for $80 million. You leave yourself
an enormous margin. When you build a bridge, you insist it can
carry 30,000 pounds, but you only drive 10,000 pound trucks across
it. And that same principle works in investing. "

But the real curveballs are the next two quotes from Buffett and Charlie Munger:

Buffett- "We don't formally have discount rates. Every time we start talking about this, Charlie reminds me that I've never prepared a spreadsheet, but I do in my mind. We just try to buy things that we'll earn more from than a government bond - the question is, how much higher?"

Munger- "Warren often talks about these discounted cash flows, but I've never seen him do one. If it isn't perfectly obvious that it's going to work out well if you do the calculation, then he tends to go on to the next idea."

It seems as though Buffett doesn't actually use any rate at all! But is this even surprising? This is, after all, the same investor who doesn't have a computer or a calculator at his desk.

Buffett's strategy is to find fantastic businesses that are so cheap that any reasonable rate would give you a fantastic return. He calculates numbers quickly in his mind and dismisses them if there is any doubt whatsoever about their returns.

What I use

Unfortunately, I am not Warren Buffett and cannot find companies so cheap that the discount rate in my models are irrelevant. For this reason my value investing friends and I use a nice and easy number: 10%. We use this consistently with every single stock we value. When interest rates rise we are thinking about raising it to 12%.

We like 10% because it is quite high in this environment and screens out a lot of investments which could do us damage. We realize that there are many flaws in this system, but we like it better than trying to assess risk on a firm by firm basis with an equation that doesn't work. Furthermore, we have two more weapons under our belt to reduce risk since our rate is ambiguous:

1. No Growth

Our future cashflows do not include growth. Realistically nobody knows what will happen in the future and we try to stay away from even more assumptions in our models. Not adding growth tends to give us quite a low figure in valuations.

2. Margin of safety

Our second, and most important, weapon against risk is using a margin of safety when buying stocks. With the S&P 500 (NYSEARCA:SPY) up 20%+ these days, it is quite hard to find a company that is undervalued using the 10% discount rate, no growth, and a margin of safety.

We like to use 2/3rds as our margin of safety for even more security. For example, if after discounting back the cashflows with no growth we see a fair value of $9 a share, we will only purchase the stock at $6.

Unfortunately, this requires a lot of patience and can be quite frustrating at times (why my username is Patient Value).

Source: WACC Is Flawed, Use Warren Buffett's Approach Instead