The WACC and Its Impact on Company Valuation

Company Valuation and the DCF Method

The value of a company is ultimately determined by the future returns an investor can expect from it. This fundamental idea also underlies the earnings value method, a classic company valuation technique. In this method, future profits are discounted to their present value, which determines the company's value. In recent years, the earnings value method has increasingly been replaced by the Discounted Cash Flow method (short: DCF method). This involves discounting based on the Weighted Average Cost of Capital (WACC).

WACC Method

The Weighted Average Cost of Capital (WACC) is used within the DCF method as an approach for company valuation and helps determine the minimum return on investment projects. The WACC method is applied in company valuation as it determines the company's value through discounting. The cost of capital rate is calculated based on the ratio of equity and debt capital to the total capital.

The DCF Method Compared to the Earnings Value Method

While the earnings value method is based on future profits, the DCF method considers future cash flows from business operations. These two figures do not necessarily align. From an investment theory perspective, the cash flow-based approach is the more precise method.

The DCF method is well established in the Anglo-American region, whereas the earnings value method is a German specialty. Due to the internationalization of company transactions, the DCF method is increasingly gaining acceptance in Germany as well. Nowadays, alongside the earnings value method, the DCF method is recognized by the renowned Institute of Public Auditors in Germany (IDW) under IDW Standard S1 as an equally valid valuation method. This recognition is essentially the "license" for its use in Germany.

Free Cash Flow as the Basis of Valuation

The basis for company valuation using the DCF method is the so-called free cash flows (English: Free Cash Flow, FCF). These are the periodic cash surpluses remaining after investments from operational business activities, theoretically available for distributions to owners and interest payments to lenders. Unlike profits, Free Cash Flow can be relatively unaffected by accounting policies and is therefore an "objective" measure.

There are two primary methods to determine company value using the DCF method: gross capitalization (Entity Method) and net capitalization (Equity Method). The WACC only plays a role in gross capitalization, so this will be discussed below. The process involves two steps: first, the total company value is determined by discounting and summing the expected Free Cash Flows. In the second step, the market value of equity—the actual company value—is calculated by subtracting the market value of debt capital from the calculated total company value.

The WACC and the "Correct" Discount Rate

In addition to accurately determining Free Cash Flow, the choice of the "correct" discount rate for discounting is crucial in the DCF method. There are various approaches for this; the WACC approach is particularly common in practice. WACC represents the average cost of capital, calculated based on the shares of equity and debt capital in the company's total capital. It is thus a weighted average. The formula is simplified as follows:

WACC Rate = (Equity Ratio x Cost of Equity) + (Debt Ratio x Cost of Debt)

Determining the Cost of Debt

The cost of debt can be calculated using the interest rate the company being valued must pay to debt providers. It is also essential to consider the so-called Tax Shield. This refers to the tax savings from the tax deductibility of interest on debt. The calculation of the cost of debt is as follows:

Interest Rate on Debt x Tax Shield = Interest Rate for Calculating Cost of Debt

Often, empirical values in the form of the actual interest paid are used to calculate the cost of debt.

Determining the Cost of Equity

While empirical values are usually available for the cost of debt, determining the cost of equity is more challenging as there are no fixed payment obligations. Theoretically, the cost of equity corresponds to the risk-free interest rate plus a market-conform risk premium for the company-specific risk.

In modern financial theory, the Capital Asset Pricing Model (CAPM) has been developed for valuation. The beta factor of comparable publicly traded companies is used in this model, indicating the risk of investing in a stock compared to the overall market. The formula is as follows:

Risk-free Interest Rate + (Beta Factor x Market-Conform Risk Premium) = Interest Rate for Calculating Cost of Equity

However, since the CAPM is primarily applicable to publicly traded companies, other estimates must be used to determine the cost of equity for different companies.

The Impact of Taxes

The above formula applies "pre-tax," meaning taxes are not considered. However, taxes do play a role in company valuation, as cash flows are taxed differently depending on their use. Interest on debt is tax-deductible (so-called Tax Shield), whereas surpluses over which owners decide are not. Retained earnings, meaning profits kept within the company, are taxed at the corporate level, while distributions are taxed at the owner's level. When calculating a "post-tax" WACC rate, this is typically done by reducing the cost of debt rate by the "tax deduction rate."

Conclusion

Company valuation is a crucial first step when considering selling a company, as many subsequent processes in the sale process depend on it. Therefore, every seller should have a basic understanding of the topic and know the most important valuation methods and the associated interest rate concepts.

In summary, a company's value can essentially be traced back to the returns investors can expect. Future cash flows are discounted to their present value. Discounting has a significant impact on company value; high-interest rates reduce value, while low-interest rates positively influence company value. For this reason, sellers should be familiar with important interest rate concepts.

Accordingly, this article focuses on the WACC approach, whose importance increases with the growing use of the DCF method. To better understand, the DCF method was compared with the traditional earnings value method, and the basis of the valuation, Free Cash Flow, was described. Additionally, the formula for calculating the WACC rate was derived from its individual components. Finally, the impact of taxes on company valuation was discussed and explained when they should be considered.

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