Hi TradFi Team,
This is my 2nd blog post in my TradFi for HIVE series. My series is not really a "collection of posts" because the topics and my direction could easily change. But for those who are interested in how to create a "collection of posts" on HIVE, just let me know in the comments and I don't mind explaining it in detail.
So WACC (Weighted Average Cost of Capital) is one of the most important tools when trying to understand a company and the firm's valuation. Like most concepts in finance, WACC is highly theoretical and also based on a set of assumptions.
Assumptions are never perfect and there is always some level of art that goes into building financial models and building a valuation of a firm. Friendly reminder, most of the concepts I am covering in my blogs for the TradFi Community are easy to access for free. I have spoken to one of these free resources in my other posts and in comments; this free resource is Investopedia. Investopedia is normally "correct" and is much cheaper than buying text books. I am adding my own words and flavor to this content but if you want a free resource to review as well, you can find it here https://www.investopedia.com/terms/w/wacc.asp
Weighted Average vs Simple Average
So to start out, I think it is best to cover what a weighted average is; before we get into Weighted Average Cost of Capital. There are 2 commonly used averages in mathematics. Typically people just say "average" when doing math. Once you start using weighted averages people will refer to the most commonly used average as a "simple" average.
An Average (or simple average), is where you sum all values and divide by the number of values.
A weighted average is where you assign "weights" to the average calculation and do not divide by the number of values.
I will start with an "easy" example to show the difference between a weighted average and a simple average.
Let's assume you are a potato farmer and you want to know the average number of potatoes you pick per season.
Below is a table to show what you picked across 14 seasons.
The simple average = Total Potatoes Picked / Number of seasons
So on average you pick 807 Potatoes / 14 seasons = 57.64 Potatoes per season.
But wait a second! Let's assume you are a dragon potato farmer and you are super "smart."
A dragon potato farmer naturally knows that not all seasons are the same. Some seasons are longer than others. So we would also like to know the average number of potatoes picked when adjusted for how long the season was for each year.
In the below table we do this by weighting by the number of days that was in each season. The total number of days was 1410 across 14 seasons so we will divide each season's days by 1410 to determine our weights.
Your weights should sum up to 100%.
Then we will multiply our potatoes harvested each season by our weights. The sum of all potatoes picked * weights = the weighted average for potatoes picked per season.
So when you adjust for the variation of days in a season, on average you get about 59.31 Potatoes per season.
Ok so that was a simple example using potatoes. But it is important to understand there is a difference when looking at simple averages and weighted averages. That is especially true when trying to understand WACC (Weighted Average Cost of Capital).
What is cost of Capital?
Before we get into WACC, it is important to understand Cost of Capital. Cost of Capital is a little complicated to understand, but once it resonates with you, it is "easy" to interpret. Cost of Capital is the return a company requires to be able to pay its equity holders and debt holders back. It is also understood as the return required by investors. If you are an equity holder, you require a specific return on the firm's equity. If you are a debt holder, you require a specific return on the firm's debt. Your required return is going to be based on some level of risk. If you invest in something that is low risk, your required return is much lower than if you invest in something that is high risk. This is true for the company as well. High risk companies must have larger returns than low risk companies to fund their investor's "demands." Typically, if a company does not meet its required return, it is no longer able to get capital from investors and the company in question "fails."
What is WACC?
(WACC) stands for Weighted Average Cost of Capital. So it is a combination of the 2 concepts listed above. It is a combination of Weighted Average and Cost of Capital.
Most companies have a cost of debt and a cost of equity. Companies rarely have a 50% equity and 50% debt capital structure so a simple average to get a firm's cost of capital is usually not possible. Using a simple average here would be wrong in most cases.
Formula for WACC:
An Example of Calculating WACC!
For simplicity, let's assume our dragon farmer's business is publicly traded and we can easily calculate all these numbers. I am NOT going to show how to calculate cost of equity or cost of debt in this blog post because that is "a lot" of information and it will make this blog post a lot harder to digest if I force all that information in 1 blog post.
So let us assume the dragon potato farmer's business is publicly traded. With the business being publicly traded it is much easier to calculate WACC because the Market Value of Equity and the Market Value of Debt (for the most part) are publicly available.
The Dragon's Potato Farm has:
Market Value of Equity = 200m
Market Value of Debt = 100m
Cost of Equity = 20%
Cost of Debt = 12%
Also, this potato farm is in the Cayman Islands so they do not pay corporate taxes. (Normally you would incorporate the benefit of interest expense being tax deductible into the cost of debt but for simplicity I am avoiding that for now).
So we can plug all the above assumptions into our formula here:
So, this potato farm needs to make about 17.33% in annual returns to pay back equity holders and debt holders. Now obviously, an equity holder does not receive a payment each year unless they sell their shares. Debt holders typically get paid on a regular basis. So this is one of the many aspects in which WACC is theoretical.
A List of Callouts Related to This Post:
I have self upvoted this post. I am maintaining the standard that I will self upvote if a post is important to me and I want it to be seen; especially if I want it to be seen outside of my TradFi community. I used to downvote based on self upvoting. I no longer do that as a reason if the person seems to do it based on the posts they care about the most. Some people only post if they care about it, and that is fine in my mind.
The use of content in the public domain is legitimate in my opinion. The difference between what I do and some of the content I downvote is people try to spin their content as original. The part of my content that is AI is clearly identified as such in my post. The pictures are created using AI and I do not own them. Anyone can use these pictures I added to my post and I cannot stop you through downvotes or any other method. This content is part of the public domain as I understand it.
WACC can include an adjustment for tax rates or preferred stock. I am not getting into that for this post because that is "advanced" knowledge which makes understanding the "basics" harder.
A List of Callouts for the TradFi Community:
We will soon be differentiating between comment content creators and blog post content creators in our community. I will make this distinction and I will be open to being lobbied on my decisions. Lobbying my decisions must be done on chain.
I am transitioning to only upvoting member comments through the @tradfi-curator. I am sure our members noticed this but I just wanted to be transparent and I am doing that publicly in this post.
I will continue to 100% upvote the authors who contribute to our community. If I have a problem with your content or want to see more, I will let you know in the comments. Everyone who contributes to this community is a valued member of the community in my mind. I cannot do this without you and I appreciate that.
Some people in our TradFi community have "better" comments than others. As a downvoter, I am in a weird spot when it comes to differentiating between "good" and "bad" content. If someone feels like we need to take extra steps to reward the best comments and posts, I am open to creating another curation account for this task but would want a member of the community to take up this task. This role would not be paid and you will only get "status" as the person who does this within our community. Ideally, if this role is created, we will transition between users regularly over time. If the person in question never gets tired of doing this "work," we will not transition the role for a "while."
I need a company to do a WACC for in the future. I do not want to pick one of the companies I am investing in for obvious reasons. If that reason is not obvious just ask me in the comments. If there is a company you are interested in its WACC being covered please let me know in the comments. There is a chance I will tell you no for valuing the company in question. If I tell you "no" I will give you a reason and hope you give me another company to consider.
Best Regards,
Hurtlocker
