Within the finance world, a concept which many individuals use to analyze a specific firm is weighted-average cost of capital, or WACC. At the highest level, WACC represents the cost of capital of the firm to do business. Specifically, this figure is a percentage amount that the firm must generate on projects to satisfy creditors and equity investors. If a firm is unable to meet their weighted-average cost of capital, they will eventually be faced with defaults to creditors or decrease in share demand from equity investors.
WACC traditionally is calculated using the below formula:
Since the S&P 500 encompasses many sectors and industries, it is important to point out that WACC is not industry specific. This means that regardless of the company or industry, WACC is equally as relevant. One of the key inputs to the WACC calculation is beta, or firm-specific risk. Beta helps us arrive at the cost of equity by accounting for the firm-level risk that is not explained by the overall market movement. By using WACC, we investors can comprehensively view the basic cost which all companies must overcome to continue operations.
This formula comprehensively encompasses the key methods by which a firm raises funds in the capital markets. In order to arrive at the inputs to the formula, analysts typically spend lengths of time scouring the filings of a company. Through this research, an analyst is able to construct a comprehensive number which represents the percent return required by investors. It stands to reason that if a company cannot satisfy its investors with its current projects, it will eventually become non-operative. Since a company must meet its requirements as established by investors, it makes sense that any company which is earning a return on projects higher than its WACC represents a solid investment since it is attempting to maximize the value for stake-holders. In order to measure return on projects, a fair metric is return on equity. This metric is very straightforward in that it is after tax net income divided by shareholder equity. If a firm is generating a return on equity higher than its weighted-average cost of capital, it is making good use of stakeholders' investments.
Rather than studying a single company, I have decided to present my findings on the entire S&P 500. I have computed the WACC and return on equity for every firm in the S&P 500 and have presented my findings in the below chart.
In the above chart, two things can be seen - the weighted-average cost of capital and the return on equity. The red line shows the WACC from least to greatest for each company and the dark blue line shows the company's respective return on equity. This analysis is powerful in that not only does it comprehensively bring a significant quantity of market data into one location, but it also shows the relative amount of companies meeting their cost of capital and those that are not. As can be seen in the above chart, the majority of companies on the S&P 500 are strongly outperforming their required return on investors' capital.
In order to better understand the strength of the S&P 500 companies, I did additional research and found that 94% of companies are exceeding their weighted-average cost of capital. This means that the vast majority of firms are generating favorable returns on investments and are in a position to expand from a financial standpoint. The ramifications of this simple analysis can be huge. Not only are these firms satisfying their owners, but they still have capacity to expand. For example, if a firm can undertake projects that earn a 15% return each year, they should theoretically be raising capital and completing these projects as long as they can raise capital at a rate less than their expected return. According to this analysis, 94% of S&P 500 companies are in a position to expand and continue the growth which placed them on the index in the first place.
I attempt to develop my thoughts fundamentally and execute technically. I have found that this method allows me to enter the market at strategic moments and hopefully reduce the risk associated with my investment. With this said, I have examined the technical environment of the S&P 500 ETF (SPY) and I have determined that we are currently in the pull-back of a strong uptrend. This trend has been in place since 2009 and I believe that the trend will continue given the fundamental strength in the underlying firms of the index.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SPY over the next 72 hours.