DCF - WACC - Guide PDF

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Discounted Cash Flows: The WACC from Scratch August, 2020 Marco Navone, [email protected]

FactSet provides an estimate of the WACC for US public companies. In the previous portion of the tutorial we have seen how to estimate the beta of private companies based on the beta of their comparables. Here we will learn to estimate the WACC for public companies for which FactSet does not provide the calculation, namely non-US listed companies. These companies have publicly available stock prices, so we do not need to estimate the beta using the comparables, we can simply estimate the beta by regressing the stock returns against the relevant stock market index. For sake of consistency we want to follow the methodology employed by FactSet as closely as possible. So, our first step will be to analyse this procedure by clicking on “Methodology” in the WACC panel.

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From this page we learn the following: Beta

Based on a regression model, relative to the S&P 500, i.e. the U.S.'s local market index, calculated over the last three years, weekly. It's then adjusted per Blume's method, which assumes over the long-term Beta will converge to 1. Blume's method is (2/3(Beta) + 1/3)

Risk Premium

The latest equity risk premium value from Professor Aswath Damodaran.

Cost of Equity

Based on CAPM (capital asset pricing model) which is simply the risk-free rate + beta * risk premium.

Risk Free Rate

The U.S. government 10-year rate as of the latest close sourced from Tullet Prebon (Available in FactSet in the Markets section).

Cost of Debt

Based on the bond and loan securities a company has issued (sourced from DCS and Fixed Income terms and conditions). It weights, by amount outstanding, the yield to maturity (or reported coupon if a YTM is unavailable) and sums it together to come to a cost of debt. If there is not enough debt outstanding to calculate the cost of debt using individual securities, the report will use FactSet's U.S. Corporate Spreads matrix to find a spread. Finally, if Corporate Spreads are unavailable, the report will use the historical cost of debt using the company's reported interest expense divided by the total debt, averaged over the last three years.

Effective Tax Rate

The three-year average of income tax FF_INC_TAX divided by the three-year average of pretax income FF_PTX_INC.

Cost of Preferred Equity

Similar to the first/main cost of debt calculation, calculated as the weighted average yield (coupon when yield is not available).

We can use this information to derive the WACC in a way that is consistent to the FactSet methodology.

1. Cost of Equity To estimate the cost of equity we need three elements: the beta, the equity risk premium and the risk-free rate.

1.1 The Beta FactSet estimate the beta by regressing the weekly percentage price change of the stock over the weekly percentage price change for the relevant market index using the last three years of data. For the US the market index is the S&P 500 (what about Australia? What would you use?). We can download the price changes from the Price History section within the Company Security Tab. We can do the same for the market index. In FactSet a market index is just another security and can be searched as any other company using the name or the code ( SP50 for the S&P 500).

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Once we have downloaded the data in Excel we can perform a linear regression using the appropriate functions or tools. Technically we do not need to perform the entire regression. We only need the slope coefficient, and from statistics we know that if we have 𝑦 = 𝛼 + 𝛽𝑥 + 𝜀 𝛽󰆹 =

𝐶𝑜𝑣(𝑥, 𝑦) 𝑉𝑎𝑟(𝑥)

We can estimate the beta using the population-adjusted versions of the variance (VAR.P) and covariance (COVARIANCE.P) excel functions. Performing this calculation using data available as of today the result is 𝛽󰆹 = 0.98476 To this result FactSet applies the so-called Blume’s adjustment. This assumes that the betas oscillate around one, so when a company has an historical beta lower than one the future beta is likely to be higher (and vice-versa). The final beta will thus be 𝛽𝐹𝑎𝑐𝑡𝑆𝑒𝑡 =

1 2 + × 0.98476 = 0.98984 3 3

1.2 Risk-Free rate As a proxy for the risk-free rate, FactSet uses the current yield-to-maturity of a 10-year government bond. This is a reasonable assumption as long as the country has high credit rating. For most countries, these YTM can be found in the Markets tab under Fixed Income/Government Yields.

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1.3 The Equity Risk Premium The ERP represents the additional return investors require to bear the risk of equity investment (versus investing in safer government securities). This quantity is not directly observable and requires a number of assumptions and approximations. In some applications, the ERP is simply approximated with the long-term excess return of a stock market index over the risk-free rate. FactSet opts for a more complex approach where this quantity is derived according to a methodology devised by Professor Aswath Damodaran of NYU. As it’s often the case, more complex approaches lead to simpler solutions. This is one of those cases because prof Damodaran kindly provides updated estimates of the ERP (for the US as well as many other countries) on his website. At the time of this document FactSet it’s still using the July 2020 COVID-Adjusted ERP of 5.23%.

1.4 Putting Everything Together According to the FactSet methodological document, the estimation of the cost of equity is “Based on CAPM (capital asset pricing model) which is simply the risk-free rate + beta * risk premium.”, and we have: 𝑟𝑒 = 𝑟𝑓 + 𝛽 × 𝐸𝑅𝑃 𝑟𝑒 = 0.7037% + 0.98984 × 5.23% = 5.8806%

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2. After-Tax Cost of Debt The estimation of the after-tax cost of debt requires us to recover information on the pre-tax cost of debt and the effective tax rate paid by the company.

2.1 Pre-Tax Cost of Debt According to the methodological document, this number can be recovered from three different sources: 1. Based on the bond and loan securities a company has issued (sourced from Credit Analysis/DCS Detail in the Company/Security Tab). 2. If there is not enough debt outstanding to calculate the cost of debt using individual securities, the report will use FactSet's U.S. Corporate Spreads matrix (from Fixed Income/Corporate Spreads in the Markets tab) to find a spread. 3. Finally, if Corporate Spreads are unavailable, the report will use the historical cost of debt using the company's reported interest expense divided by the total debt, averaged over the last three years (from the Financials/Income Statement in the Company/Security Tab). 2.1.1 Method One: the detailed approach The first methodology is quite onerous and, as you will see from the following example, it’s normally quite difficult to reach the same conclusion as FactSet, due to the difficulty of recovering the actual cost of all the loans and bonds outstanding. Let’s see what we can find on our company. From Credit Analysis/DCS Detail in the Company/Security Tab we see that Ball has a number of outstanding loans and bonds. According to the methodology we should calculate the weighted average of the YTM of all these securities.

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For the bonds the YTM is provided (in the column YTW), while for the loans we need to search the contractual cost from the details of the individual security. For example, if we click on the Senior Secure Term Loan A, it will open a security tab from which we can explore the coupon details. We see that this loan has a variable rate based on LIBOR.

By clicking on the Floating Index Pricing and Fee detail we see that the spread on the LIBOR is based on the Net Leverage Ratio of the company.

Specifically, we see that as long as the Net Leverage ratio is below 3, the company will pay LIBOR + 1%. If the leverage is between 3 and 4 the company will pay LIBOR + 1.25%. Finally, if the leverage goes above 4 the cost of the loan climbs to LIBOR + 1.5%. From the DCS Overview Tab we can see that the current Net Leverage Ratio (Net Leverage divided by EBITDA) is above 4, so the coupon is LIBOR + 1.5%.

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To find the current value of the LIBOR we need to go in the Markets tab in the Fixed Income/Lending Rates and we can see that the current 12M LIBOR for US$ is 0.46%

So, in total the cost of this loan is, as of today, 1.96%. We can repeat this calculation for the two revolving credit facilities (they have the same cost structure as the loan…). In conclusion, we find the following sources of funds

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Item Senior Sec. Revolving Credit Facility - Multi Currency Senior Sec. Revolving Credit Facility Senior Sec. Term Loan A Ball Corp Ball Corp - 700M EUR Ball Corp Ball Corp - 750M EUR Ball Corp Ball Corp Ball Corp - 550M EUR Ball Corporation 2.875% 15-AUG-2030 TOTAL

Amount 225 575 653 750 786.2 1000 842.4 1000 750 617.7 1300 8499.3

Weight (%) 2.6% 6.8% 7.7% 8.8% 9.3% 11.8% 9.9% 11.8% 8.8% 7.3% 15.3% 100.0%

Cost

Cost x W

1.96 1.96 1.96 1.79 1.12 2.09 1.1 2.67 2.75 1.58 2.99

0.05 0.13 0.15 0.16 0.10 0.25 0.11 0.31 0.24 0.11 0.46 2.08

The weighted average cost of debt (2.08%) is significantly lower than what is reported in FactSet (2.97%). This is likely due to our inability to recover all the relevant details on the individual loans (for example the relevant LIBOR could be the average of the last X months, etc.). 2.1.2 Method Two: the Credit Spreads The second suggested methodology involves the use of Credit Spreads. From the Credit Analysis/DCS Overview tab we see that Ball has a BB+ rating

From the same page, we can also download the breakdown of debt by maturity and we can calculate that the average maturity is 4.52 years.

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Armed with this information we can go the Markets section of FactSet in Fixed Income/Credit Spread tab and look for the credit spreads, over LIBOR, for firms in the Process Industries sector.

As we can see we only have spreads for BB and BBB bonds, and only for bonds with maturity of 3 and 5 years. Using the two maturities, we can easily do some linear interpolation to recover the spread given our average maturity of 4.52 years. Moving between ratings it’s trickier. Since the relevant notches are BBB, BBB-, BB+, BB we could derive the spread for BB+ by taking 75% of the BB spread and 25% of the BBB, assuming equal distance between notches. This is not very precise but can work in a pinch. The results is

BBB BB BB+

3 73.29 239.72 198.11

5 83.24 307.61 251.52

4.52 80.85 291.32 238.7

The estimated spread over the LIBOR is 2.39%. If we sum the current value for the 12M LIBOR (0.46%) we obtain 2.85%, close enough to the FactSet estimate.

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2.1.3 Method Three: Average Interest Expenses Finally, according to the FactSet methodology, we can simply look at the interest expenses in the last three years. From the financial statements of Ball, we find both interest expenses in the Income Statement:

In the same way we can find total debt in the Balance Sheet or, for simplicity, in the Key Items tab:

With these values can simply calculate the average cost of debt for the last three years.

Interest Expense Total Debt Cost of Debt

DEC '19 329 8056 4.08%

DEC '18 315 6729 4.68%

DEC '17 301 6971 4.32%

Average

4.36%

As we can see the three methodologies lead to three different results. The first one is in principle the most precise, but it is also the most difficult to execute, and could lead to serious error if we cannot recover all the relevant information on the different debts correctly.

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Following the indications of FactSet, if the first methodology is not available the second one (based on credit spreads) should be preferred to the third one (based on historical interest expenses) because it’s more forward looking. The last one has the advantage of being easier to execute.

2.2 The Effective Tax Rate This quantity is estimated by taking the 3-years average of the ratio between Income taxes and Pre-Tax Income. These values can easily be found in the Income Statement

Pre-tax Income Income Taxes Tax Rate

DEC '19 608 71 11.68%

DEC '18 633 185 29.23%

DEC '17 514 165 32.10%

Average

24.33%

2.3 The Cost of Debt Once we have the pre-tax cost of debt and the effective tax rate, the after-tax cost of debt is simply 𝑟𝑑 = 𝑟𝑑𝑝𝑟𝑒−𝑡𝑎𝑥 × (1 − 𝑇𝑎𝑥𝑅𝑎𝑡𝑒 ) 𝑟𝑑 = 2.847% × (1 − 24.33%) = 2.154%

3. The Target Capital Structure To calculate the WACC we need an estimate of the target capital structure of the company. To keep the process transparent, FactSet simply uses the current values: •

Equity: Fully Diluted Market Capitalization

•

Debt: Total Debt minus In-The-Money Convertible Debt

These values can easily be recovered from the breakdown of the Enterprise Value provided in the Snapshot of the company

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So, in this case we have the following breakdown of the total capitalization of the company

Equity Debt Total Capital

Amount 25,360.75 7,681.00 33,041.75

Weight 76.75% 23.25% 100.00%

We should notice that this specific solution, using the current capital structure of the company, has the advantage of being neutral and easy to apply. We should also notice that it is not necessarily the theoretically correct solution. The cost of capital used in the DCF is used to discount future cash flows and should represent an estimate of the expected cost of capital. If we have reason to believe that the current capital structure is not representative of the foreseeable future of the firm, for example because we expect to issue new debt in the near future (or to pay back some of the existing debt), we may want to adjust these weights to reflect the target capital structure of the firm.

4. The WACC With all the information collected, we can finally estimate the Weighted Average Cost of Capital of the firm: 𝑊𝐴𝐶𝐶 = 𝑟𝑒 ×

𝐷 𝐸 + 𝑟𝑑 × (1 − 𝑡) × 𝐸+𝐷 𝐷+𝐸

𝑊𝐴𝐶𝐶 = 5.8806% × 0.7675 + 2.154% × 0.2325 = 5.014%

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As we can see, notwithstanding our problems with the derivation of the cost of debt, we were able to replicate the FactSet calculation with a good degree of approximation. TO DO In the Group assignment you will have to value an Australian company. Since FactSet does not calculate the WACC for non-US companies be sure to address the following issues: 1. What market index should be used in the regression to calculate the beta of an Australian Company? 2. Where can I find in FactSet the Risk-Free rate for Australia (using the YTM of a 10Y government bond)? 3.

Where can I find, on the Damodaran Website, the estimate for the Equity Risk Premium of other countries?

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