Fixing Widespread Mistakes in Valuation. Part 1: Never Use WACC
Correcting the flawed practices almost all business schools teach and professionals employ
Disclosure: This article discusses finance techniques and is for people familiar with the concepts of fundamental valuation and Discounted Cash Flow (DCF).
With nearly 20 years in the finance industry, I’ve been watching practitioners around the world, including myself, make traditionally ingrained mistakes in valuation over and over. To contribute to improving things, in 2021 I started teaching Applied Corporate Finance to MBAs at Caucasus University. But with just around 40 students per year, you won’t fix globally deep-rooted flaws. Hence, I decided to write a three-part series about this subject to reach a broader audience, and to at least partially redeem the valuation sins of my youth.
This Part 1 is about the most prominent and widely used concept in fundamental valuation — WACC, Weighted Average Cost of Capital. As we will see, WACC is a flawed tool due to both logical and mathematical complications and should be dropped from valuation practice altogether.
Here are the complications caused by using WACC and the common mistakes coming out of them.
Complication 1: Reflecting tax shields in the cost of debt does not reflect reality and gives birth to mathematical problems in WACC
The valuation exercise divides the task of analysing the company into two components:
- A. The cash flows
- B. And the required level of return to be extracted from those cash flows according to their riskiness — the cost of capital
Based on that:
- A. Cash flows projection should always reflect our best estimate of the money generated in the future and available to the sponsors — equity and debt holders
- B. While the cost of capital should always reflect the risk level of the company generating those estimated cash flows — the level of return these sponsors should request
Sounds simple, right? We already knew it. Then why do we reflect the item which belongs to (A) the cash flows in the (B) required return based on risk level?
Tax shields create extra cash flows for the company because they reduce cost, that is a fact. But the risk level of the company's cash flows does not decrease because debt interest lowers taxes.
Below is the Fundamental Risk Equation based on the Modigliani–Miller theorem of corporate finance:
The total risk of the company’s operations generating cash flows is passed to equity and debt holders and then split between them. We can only reduce the risk born by the right side parties of this equation by first reducing the risk level of the left side entity. We decrease the company’s risk through better management, more stable sales, more reliable infrastructure, or other business factors. We don’t decrease the company’s risk by injecting debt and bringing tax shields, so the risk passed to the sponsors should not decrease either.
Reflecting tax shields in the cost of debt and eventually in WACC distorts the true logical picture of both cash flow estimation and the cost of capital
- Future cash flows are estimated wrong as they have overstated taxes
- And the WACC no longer reflects the risk investors are taking — it is polluted by blending an extra component which just saves costs and has nothing to do with the risk of the company
A common mistake that follows:
Practitioners show incorrect cash flows in the valuation model as the tax shields are not reflected there, and the polluted WACC does not reflect the risk level of the company. So, the valuation process starts on the wrong foot from the beginning.
More importantly, reflecting tax shields in the cost of debt gives birth to mathematical problems leading to other complications of WACC and is the source of its biggest inaccuracies. We will demonstrate this in detail in Part 2 of this series.
Complication 2: To lever up the cost of equity used in WACC, we need a debt-to-equity ratio. To estimate the true debt-to-equity ratio, we need to divide the market value of debt by the market value of equity. The market value of equity is what we are looking for — output is needed as an input.
There are different formulas to lever up the cost of equity, but the debt-to-equity ratio participates in all versions. It does not matter which one we take for this illustration, so let’s take the one which is real-life appropriate (Why this version is real-life appropriate we will explain in Part 3 of this series):
To demonstrate how to lever up equity correctly, for simplicity let’s assume that we have just a one-year cash flow company. The market value of debt was provided by our favourite banker (we should have one). Now we need to estimate the debt-to-equity ratio. We do the following steps:
- 1) Take as a first approximation the book value of equity, or for the publicly traded company the market capitalisation
- 2) Lever up the company’s cost of equity with the market value of debt divided by the book value of equity or market capitalisation
- 3) Estimate WACC:
and get to the answer of the market value of equity
- 4) Now plug the market value of equity we received back to the formula of levering up the cost of equity, estimate the new 2nd WACC and new 2nd market value of equity
- 5) Now plug this new market value of equity back to the formula of levering up the cost of equity again, estimate the new 3rd WACC and new 3rd market value of equity
The process continues in the circle of WACC until usually on the 4th or 5th circle the input market value of equity we plug into the debt-to-equity ratio converges to the output result. We can model it in a spreadsheet, but the process is complicated and can lead to errors.
A common mistake that follows:
Practitioners stop at step one in the list above, i.e., they evaluate debt-to-equity ratio and WACC with the initial value of equity — book value or market capitalisation and get the wrong answer.
Complication 3: We need to change WACC every year the company’s debt-to-equity ratio changes
As if running around in the circles of one-year WACC was not troublesome enough, we need to do it again every time the company’s debt-to-equity ratio changes, and it changes a lot in real life.
When conducting valuation, analysts project at least 3 to 5 years of cash flows forward. During the projection period debt often has an amortising schedule. As we estimate the company’s WACC initially and use it to discount year-1 cash flows, the year-2 cash flows are generated by different capital structure, and we need to change WACC. We need to change it every year as each year’s cash flow is generated by a different capital structure. Just imagine how onerous and prone to errors this task is.
In fairness to academics, we should mention that in contrast to other complications of WACC, at least this one is written in the majority of good corporate finance textbooks.
A common mistake that follows:
Practitioners discount every year’s cash flows at the initial estimated WACC based on the first-year capital structure, reflecting incorrect tax shields for subsequent years and getting the wrong answer
This mistake becomes dramatic when we value a company during the LBO (Leveraged Buyout). Analysts project the cash flows until the debt is repaid or significantly reduced and calculate terminal value afterwards. Yet, when calculating the present value of the later projected years and terminal value, they discount it at WACC which incorporates the first year’s tax shields in the cost of debt. Effectively, they attribute large initial tax shields to the years when the company does not have debt anymore or has very little of it. Very significant overvaluation occurs.
Complication 4: Debt-to-equity ratio is not a primary measure of leverage. Even companies which run at stable leverage don’t use debt-to-equity as a primary metric
CFOs around the world do not run the business targeting any level of debt-to-equity ratio generally, as this ratio is at best a tier 3 measure of leverage. The two primary measures of leverage used in real life are:
- Net debt-to-EBITDA
- Net debt-to-operating cash flow
Where the net debt is debt minus free cash on the balance sheet not required for the company’s operations.
We already noted in Compilation 2 that properly calculating even the initial debt-to-equity ratio is problematic. To partially bypass this issue, finance textbooks recommend just assuming some debt-to-equity ratio, at least in the terminal period. But this is impractical because companies who want to keep constant leverage are usually managed with constant net debt-to-EBITDA. Constant net debt-to-EBITDA does translate into a constant debt-to-equity ratio if all other factors are kept stable, but the calculation of future leverage and tax shields will still be disconnected from reality if the debt-to-equity ratio is used as a metric.
A common mistake that follows:
Practitioners estimate the level of future leverage and the tax shields based on a metric which is almost never used in practice as primary guidance; Hence the chance of correct estimation is slim to none.
Why does the investment community still make these common mistakes?
There are several reasons:
1. Many practitioners do not know about these mistakes
Many practitioners mostly just take the formulas written in the books and directly use them in the real world, without proper understanding of their assumptions and context. Unfortunately, the way finance is usually taught rewards the plain memorization of formulas rather than deep critical thinking and getting to the essence.
2. Once WACC gained popularity in the 60s of the last century, it settled as a standard. These common mistakes took the ground and got accepted or ignored
Even practitioners who know of these complications, frequently ignore them and continue doing things in a flawed way because everybody else has been doing it like this for decades. I am too guilty as charged here. Making change and persuading the entire community that things are not done right is too much hassle at work, and after several efforts, we give up and go with the flow.
3. The equity valuation is an imprecise exercise anyway as future cash flows and growth rates are not known (in contrast to bond valuation). Practitioners can get away with using imprecise methods because as time passes verifying and checking the quality of their work is difficult
Future cash flows are rarely estimated with precision. So, it is difficult to judge if valuation turned out to be incorrect because cash flow estimation had variance or because the WACC had mathematical flaws. If people can get away with an imprecise model which is generally accepted, they will not bother to go against the established norms and use a better approach, especially if their mistakes are difficult to catch and quality control.
4. Academics and finance textbook authors do not point to WACC’s limitations enough and do not give enough credit to alternative methods
As mentioned above, the majority of authors do state that WACC needs constant leverage to function correctly (complication 3). But few point to the other complications we explored here. Despite that they are aware of these flaws, in the end, the majority still write that WACC is usable in the real world as it will give us an approximation which is “good enough”. Just like from the industry professionals, we need a stronger stance from the scientists as well to change decades-long embedded flawed standards in the business world.
WACC is a very useful concept, just not for valuation
As a finance nerdy geek, I love WACC. Historically 50 years ago it helped a lot in our understanding of value creation. It is still useful to highlight insights about the impact of leverage and changing debt interest on the company. We will demonstrate this in Part 2 of this series. I taught WACC to my students to hone their financial analysis thinking and to make them understand how risk flows from the company’s operations to its sponsors. But that doesn’t mean we have to use it for valuation too. Why settle for a “good enough” approximation when better methods exist?
Do we have a better method than WACC?
Yes, there is a superior method to WACC.
It is Adjusted Present Value, APV, introduced by Professor Stewart Myers in 1974 and discussed in his seminal book Principles of Corporate Finance (by Richard Brealey, Stewart Myers, Franklin Allen and Alex Edmans). Another book, Valuation: Measuring and Managing the Value of Companies (by Tim Koller, Marc Goedhart and David Wessel) also discusses APV in good details, despite underestimating its merits. In 1997 Professor Timothy A. Luehrman published two articles about it: What’s It Worth?: A General Manager’s Guide to Valuation and Using APV: A Better Tool for Valuing Operations. He predicted that APV would replace WACC as a primary tool for analysts. 25 years later it still did not happen. APV is mentioned in other works too, but nowhere near as widely as WACC. Introductory corporate finance courses skip it altogether. No wonder it never gained much popularity.
In the next Part 2 of this series we fully demonstrate the advantages of APV — it works during both changing and constant leverage, enables us to see the sources of value, gives the flexibility to adjust and incorporate additional components, and avoids lots of mathematical complications present with WACC.
WACC and its associated mistakes are ingrained in investment practice and business school courses. While a useful tool for understanding various insights of corporate finance, with better methods available it’s time to retire it for valuation.
But even if you decide to stick with WACC, at least beware of the complications mentioned in this article and the errors following them. Keeping that in mind will help you make better decisions.