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The Weighted Average Cost Of Capital

Adam Taggart
October 19th, 2018
Peak Prosperity
Comments (27)
Read by 2,583 people

This article was originally published by Adam Taggart at Peak Prosperity

This is a re-visitation of a report I wrote back in late 2016, predicting the imminent end of zero-bound interest rates and warning of the downward pressure that rising rates, mathematically, must place on today’s elevated asset prices.

Since the publication of that report, interest rates have indeed vaulted higher. Look at how the 3-month US Treasury yield has exploded since the start of 2017:

A Little Background

When I was fresh out of college in the mid-90s, I landed a job at Merrill Lynch. I was an “investment banking analyst”, which meant I had no life outside of the office and hardly ever slept. I pretty much spoke, thought, and dreamed in Excel during those years.

Much of my time there was spent building valuation models. These complicated spreadsheets were used to provide an air of quantitative validation to the answers the senior bankers otherwise pulled out of their derrieres to questions like: Is the market under- or over-valuing this company? Can we defend the acquisition price we’re recommending for this M&A deal? What should we price this IPO at?

Back then, Wall Street still (mostly) believed that fundamentals mattered. And one of the most widely-accepted methods for fundamentally valuing a company is the Discounted Cash Flow (or “DCF”) method. I built a *lot* of DCF models back in those days.

I promise not to get too wonky here, but in a nutshell, the DCF approach projects out the future cash flows a company is expected to generate given its growth prospects, profit margins, capital expenditures, etc. And because a dollar today is worth more than a dollar tomorrow, it discounts the further-out projected cash flows more than the nearer-in ones. Add everything up, and the total you get is your answer to what the fair market value of the company is.

The Weighted Average Cost Of Capital

The DCF approach sounds pretty straightforward. And it is. But it’s still much more of an art than a science. Your future cash flow stream is entirely dependent on the assumptions you bake into the model. The difference between a 5% or 15% assumed EBITDA compound annual growth rate becomes huge when projecting over 10+ years.

But one assumption in the model has far more impact on the final valuation number than any other. And it has nothing to do with the company’s projected operations.

Recall that the DCF approach projects out the expected future cash flows, and then discounts them (back to what’s called a “present value”). This raises a critically important question:

At what rate do you discount these future cash flows?

Well, to address this, you need to ask yourself a few questions. How will the company be financing itself? It will need to deliver an acceptable return to both its stockholders and bondholders. What kind of return can investors get out in the market for a similar investment? If they can get a better expected rate of return, or similar return with less risk, they’ll put their money elsewhere.

Enter a calculation known as the Weighted Average Cost Of Capital (or “WACC”). Again, without getting too technical on you, the WACC looks at how a company is capitalized (what % with debt, what % with equity) and what blended annual rate of return the investors who contributed that capital expect. Once you’ve calculated the WACC, you put that number into your DCF model as the annual discount rate and — Voilà! — your model spits out the present value for the company.

It’s All About The “Risk Free” Rate

So, to recap:

  1. Companies (really, any asset with an income stream) are valued off of the present value of their discounted future cash flows
  2. This present value is highly dependent on the discount rate used

We just talked about how the WACC is commonly used as the discount rate (or, at least, its foundation). So how is the WACC calculated?

Here’s its formula (Don’t let it scare you; I’m not going to get all mathy on you here):

I want to point your attention to two important factors in this equation: the cost of equity (re) and the cost of debt (rd). The size of these variables has a big impact on the final number calculated for the WACC.

Re, the cost of equity, is made up of two components: the market’s current “risk free rate” + the “equity premium” that investors demand on top of that to hold stocks, which have more risk. Most folks use the current yield on the 10-year US Treasury bond as the risk free rate (which is now over 3%).

Similarly, rd, the cost of debt, has two components: the market “risk free rate” + the premium that the company’s bondholders are charging to hold debt riskier than a Treasury bond.

Note that the “risk free rate” is a critical component of both re and rd.

So, as interest rates (i.e., 10-year Treasury yields) rise, the cost of equity goes up and the cost of debt goes up, too.

Why is that so important? Glad you asked…

The Future Of Rising Rates (And Falling Asset Prices)

Most reading this are aware that we’ve been living in a falling interest rate environment for most, if not all, of our adult lives. And since the 2008 financial crisis, interest rates were held down at essentially 0% (or even lower) by the world’s central banks:

While not the only reason, this decline in interest rates has been a huge driver behind the tremendous rise in valuations across assets like stocks, bonds and real estate over the past 30-odd years.

Which begs the question: What will happen to asset prices now that interest rates have started rising again?

Well, as I hope the above lesson on the Weighted Average Cost Of Capital hammered home, when the core interest rate rises, both the cost of equity and the cost of debt go up. Mathematically, this increases the WACC used as a discount factor, thereby reducing the present value of future cash flows.

Or in layman’s terms: When interest rates rise so does the WACC, which mathematically makes valuations fall.

In my original report back in December 2016, I penned the following:

Now, we only need to care about this if we’re worried that interest rates will start rising. Maybe the central banks have everything under control. Maybe we’re at a “permanent plateau” of sustainable zero-bound interest rates.

Well, we now know the answer: It’s time to worry.

Remember how the “risk free rate” used in calculating the WACC is often the 10-year Treasury bond yield? Since writing the above, the yield on the 10-year Treasury has nearly tripled, and has recently cracked above the much-feared 3% level, the milestone at which many analysts have predicted it would cause a major correction in the financial markets:

It has taken a while for the higher cost of capital to ripple through the system, but the repercussions are now becoming apparent.

Bonds have been in sell-off mode the longest, pretty much since since l gave warning at the end of 2016:

The housing market, which is sensitive to interest rates given the see-saw mathematical relationship between mortgage rates and real estate prices (i.e., higher rates = lower prices, all else remaining equal), has started cooling off after an eight year bonanza. As we’ve recently detailed in our report Trouble Ahead For The Housing Market, the most popular formerly red-hot markets are all showing signs of stalling/declining prices.

Nationwide, versus last year, mortgage applications have tanked 15% and home refinance loan applications have declined 34%. Mortgage rates are now the highest they’ve been since 2011 — but of course, houses are substantially pricier than they were then, too. Affordability is now a huge issue increasingly restricting the pool of potential buyers, as starkly presented in this CNBC video:

Meanwhile, the stocks of home-building companies have been selling off hard since the 10-year Treasury cracked above the psychologically-important 3% threshold:

Speaking of stocks, many pundits have been attributing much of last week’s market plunge to the bite today’s higher interest rates are starting to have across the economy:

The biggest change has been an acknowledgement that rising interest rates could cool a strong U.S. economy and also put a dent in corporate earnings. The combination of the Federal Reserve hiking short-term rates last month and another increase expected in December, coupled with a spike in the 10-year U.S. government bond to a seven-year high has made stocks less attractive compared with lower-risk bonds.

Low rates and cheap money resulted in a flood of money into stocks in recent years, as people searched for bigger returns.

But now financial conditions are getting tighter.

“The wave of money that was moving into the market is now reversing,” says Savita Subramanian, head of U.S. equity strategy at Bank of America Merrill Lynch. “As liquidity is withdrawn from the market, it amplifies market volatility” and price swings.

Higher borrowing costs also make it tougher for Americans to afford houses and buy cars on credit, analysts say.

(Source)

Rising interest rates are quickly creating a political snafu. President Trump, who has enthusiastically claimed credit for the market rally that ensued after his election, is now lambasting new Federal Reserve Chairman Jerome Powell (whom Trump appointed) for departing from his predecessors’ path of quantitative easing (i.e., bringing interest rates to historic lows).

Trump is now accusing Powell of having “gone crazy“, going as far to claim that “The Fed is my biggest threat“:

Trump Blames ‘Out of Control’ Fed for Rout But Says He Won’t Fire Powell (Bloomberg)

President Donald Trump said he won’t fire Federal Reserve Chairman Jerome Powell but blamed an “out of control” U.S. central bank for the worst stock market sell-off since February.

Trump also told reporters in the Oval Office Thursday morning that he knows monetary policy better than the Fed’s leaders and continued criticizing them for interest-rate increases.

“The Fed is out of control,” Trump said. “I think what they’re doing is wrong.”

The president added that the Fed’s interest rate increases are “not necessary in my opinion and I think I know about it better than they do.”

Is this a sign Trump will pressure the Fed to reverse path, possibly even replacing Powell? Or is this just deliberate theatre on his part to position Powell as the fall guy should a full-blown market correction be in the cards?

Either way, these higher rates were inevitable and eminently predictable by the administration. Back when I wrote the original version of this report in late 2016, Trump’s newly-selected Treasury Secretary Steve Mnuchin clearly declared the following:

“We’ll look at potentially extending the maturity of the debt, because eventually we are going to have higher interest rates, and that’s something that this country is going to need to deal with.”

(Source)

Indeed, like it or not, we’re now being forced to learn how to deal with higher interest rates.

Prepare Now

The conclusion from all the above? Get ready to live through the new era of rising interest rates. It’s going to be unfamiliar territory for all of us…

What will likely happen? The unrelenting upward march in asset prices we’ve enjoyed over the past several decades is over. People won’t be able to pay as much for stuff because the financing costs will be higher.

Falling asset prices should be in the cards. We’ve already been seeing that with bonds, and housing and stocks look like they are finally following suit. The higher rates go, the farther the fall should be.

The Fed will be in a tough spot as this unfolds. Right now, the Fed is in quite a box after years of habituating the market to ZIRP. Powell seems serious about continuing to raise rates as far as the financial markets will tolerate, provided he can do so without killing the economy — which is a big “if” at this point. There’s a lot of precedent for this; historically, the Fed’s interest rate has usually followed the market vs leading it. The Fed wants to gain some maneuvering room to drop rates at some point in the future if it feels it needs to.

At some point, if we risk entering a full deflationary rout, the world’s central planners may well indeed pull out an arsenal of tricks similar to what we saw following the 2008 crisis. We may eventually see liquidity-injection programs so extreme that hyperinflation becomes a valid concern. But that time is not now.

For now, we recommend the following:

  • Get out of debt. Especially variable rate, non-self-liquidating debt (credit cards being a great example). As we’ve said many times, in periods of deflation, debt can be a stone-cold killer.
  • Read the Financial Capital chapter from our book Prosper! (we’ve made it available to read for free here).
  • Read our primer on hedging.
  • Talk with our endorsed financial adviser (again, free of charge) if you’re having difficulty finding a good one to discuss this topic with. Be sure to have positioned your financial portfolio to take into account the risks to stocks/bonds/etc raised here.

And put today’s rising interest rates to work in your favor. If you have substantial cash savings, consider putting them in short-term T-bills using TreasuryDirect, which now yield between 2.14-2.45%. That’s over 30x what the average bank savings account is currently yielding. To learn more about this program, read our (free) report here.

NOTE: PeakProsperity.com does not have any business relationship with the TreasuryDirect program. Nor is anything in the article above to be taken as an offer of personal financial advice. As mentioned, discuss any decision to participate in TreasuryDirect with your professional financial advisor before taking action.

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Author: Adam Taggart
Views: Read by 2,583 people
Date: October 19th, 2018
Website: https://www.peakprosperity.com/

Copyright Information: This content has been contributed to SHTFplan by a third-party or has been republished with permission from the author. Please contact the author directly for republishing information.

27 Comments...

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  1. Beaumont says:

    Over time, demand never covers the cost of overhead, without subsidies or loans, insured by the govt. The business model is generally to launder corporate welfare, using the bare minimum of materiel needed to effect the appearance of productive behavior.

    • durangokidd says:

      “Or is this just deliberate theatre on his part to position Powell as the fall guy should a full-blown market correction be in the cards?”

      YEP !!! 🙂

      Nice piece Adam. I enjoy seeing a well written article by someone who actually knows something about finance; rather that the economic BS from contributors like Brandon Smith whose education & experience with finance is limited to writing checks or using his Credit Card.

  2. rellik says:

    I dumped my credit union CD when it matured and switched to 91 day Tbills via treasury direct in early 2018. So I naturally agree with some of this article.
    What really bothers me is I remember when I was 8 years old my bank savings account earned in excess of 4% interest. I’m almost 63 now and the best I can get is less than 1% on a credit union savings account, credit unions typically pay better as they are usually non-profit.
    So I have a problem with this concern about interest rates when in the 60’s we had a vibrant economy with far greater interest rates( both earned and charged) than we have today.

    • Kevin2 says:

      rellik

      “So I have a problem with this concern about interest rates when in the 60’s we had a vibrant economy with far greater interest rates( both earned and charged) than we have today.”

      We built things back then that created wealth. “Wealth” now is borrowed from the future. The economy is dependent upon it. Its a different world out there today.

      • rellik says:

        K2,
        Social security, pensions, governments, et al were just as underfunded then as now. Today due to the Internet we have a far better grasp of how bad things really are. If people had had the Internet in the 1930’s they would have killed FDR for the damage he did to America and the entire world.
        Loss of manufacturing capability is a concern, but in the 60’s they were mostly making union crap. You were lucky if an engine in a Ford car lasted 50,000 miles. I now expect well over 350,000 miles out of my German designed and built “Ford” engine that is installed in my Mazda truck, that was assembled in New Jersey. My point is to use the best the market has to offer. If a man in Detroit can’t design a decent engine, then you buy the German one. You do what you can to help the Detroit guy improve his product. If American union labor cannot make an economically viable container ship, Find out why and fix the problem.
        What you are really pointing out is America has a Democrat problem.

        • Kevin2 says:

          Comparative Advantage, the cornerstone of Free Trade has put the US Textile Industry out of business because $15 / hr , today, is too much to pay labor when sub $1 / hr labor can be had in Asia. The analogy of 1960s v modern autos has a lot more to it. Precision manufacturing with robotics, auto oils (I know a tad about this) are so much better today that the best petroleum lubes in 1980s are not even salable today. Synthetic is off the chart. Computer design has significantly made a difference too.

          “Social security, pensions, governments, et al were just as underfunded then as now. ”

          Show proof. I say no. Many more people were making better relative wages and the “baby boomers” were in the workforce. The contributors post industrial evisceration have become to a great degree now have food stamps as working poor.

          Regardless in the absence of the above wealth is not being created as it was in the 1960s. Now “wealth” is being created out of thin air post August 1971. Its extremely dependent upon debt being cheap because “debt” is the “wealth” creator. Thats the difference.

          • Kevin2 says:

            Germany didn’t put US labor out of business, China did.

          • rellik says:

            K2,
            I like this back and forth.
            I wear USMC issue(I get them from the NEX)
            MARPAT pants as work pants
            around my Gentleman’s farm. I also have Rothco
            (Filipino made) pants. The American made pants
            were $15 more than the cheap assed Flip pants,
            American made is better quality and lasts longer.
            In any event both are way cheaper than Vietnamese
            made Levis 501’s. Textiles were chased out by
            government, not labor costs.
            As far as the under-funding I really don’t have the time to
            document. Anecdotally we see it today where governments are going broke trying to pay the pensions costs they approved in the 60’s, 70’s and 80’s.

            I run synthetic lubricants in all my machines.

            • Kevin2 says:

              rellik

              “Anecdotally we see it today where governments are going broke trying to pay the pensions costs they approved in the 60’s, 70’s and 80’s.”

              That is 100% fact. Regardless the pension in the 1960s and 70s were sound. Once manufacturing started to eviscerate and boomers started to retire the drain was greater than the funding/growth. Its wasn’t until the later 80s 90s that this started to become an issue.

              Asian textile, largely from Pakistan make 5% of US labor in that capacity. Wages / benefits played a major role once tariffs were dropped. Costs overseas were much cheaper, tariffs leveled that playing field.

              These 3 gents understood the necessity of tariffs to protect your indigenous industry

              “Protection of our own labor against the cheaper, ill-paid, half-fed, and pauper labor of Europe, is … a duty which the country owes to its own citizens.”
              Daniel Webster

              “The wealth … independence, and security of a Country, appear to be materially connected with the prosperity of manufactures. Every nation … ought to endeavor to possess within itself all the essentials of national supply. These compromise the means of subsistence, habitation, clothing, and defence.”
              Alexander Hamilton

              “Free trade results in our giving our money … our manufactures and our markets to other nations. … It will bring widespread discontent. It will revolutionize our values.”
              William McKinley

              “Open competition between high-paid American labor and poorly paid European labor will either drive out of existence American industry or lower American wages.”
              William McKinley

    • the blame-e says:

      Every country has its golden age. The American Golden Age ran from 1870 to 1970. What is happening now with the decline and fall of the American Empire has been happening to empires throughout recorded history. Too bad for those living now, but that’s what is going on.

  3. Archivist says:

    “Most reading this are aware that we’ve been living in a falling interest rate environment for most, if not all, of our adult lives.”

    That’s the problem with young people doing the planning. They don’t see the long view. They don’t even consider the high interest rates that many of us actually saw back in the 70s.

    • PL C says:

      I so agree; we bought our first house in 1973, 7% interest, normal for the time. Bought our second house in 1983, 12% interest, normal (and staggering) for the time. Refinanced (to 9%), paid ahead frequently, and paid off the mortgage in 1993. Those post 2000 ads that said, “Historic low rates” were actually very true; even in the first half of the 20th century, a 3 or 4% rate on mortgages would have been exceptionally good. Lots of home sellers were handling the financing for their buyers themselves in the 80’s. Read the Martin Armstrong blog, https://www.armstrongeconomics.com/blog for both the long perspective and the global perspective. Read Pater Zeihan’s book “The Accidental SuperPower” and his sequel, “The Absent SuperPower”, for the geopolitical perspective; the latter more optimistic, but also a deeper understanding of the American perspective as well as our allies and adversaries.

  4. JayJay says:

    Has anyone calculated 10,000 @ 2.14% divided by 12 months which is .178% and monthly earnings at that rate are $17.80. Uh, then there are taxes when reported to IRS??
    So, I’ll keep my money in the linen drawer.

  5. aljamo says:

    Eternal inflation built into the setup. Meat, fish prices are a joke bigger than overall food prices. All bills rise constantly. The endgame will not be pretty. What a way to run a trapped system of humans ruled and judged as profitable or not. A self defeating system.

  6. They keep printing money with nothing to back it. We will be Venezuela. People are in the stock market because they can’t get good interest on their savings. If rates actually went high enough, you would see the market empty out.

    • Kevin2 says:

      They create bubbles that collapse and with it money literally disappears. They then create more money to re-inflate the bubble. If managed well this can continue. The Achilles Heel is the removal of the USD in international transactions. Without that massive pool to dilute inflation into along with its greater purpose of giving the USD far more value than the reality of 1 + 1 = 2 the scam fails. They’ll fight WWIII in necessary to maintain the present arrangement.

      • the blame-e says:

        England, another failed empire, fought two World Wars under the delusion that the sun would never set on the English Empire. The only thing that saved them from their own insanity was the United States. Who is going to save the United States from their own sense and delusion of empire? This thing is going down. We will be lucky to survive it.

        • Kevin2 says:

          ” Who is going to save the United States from their own sense and delusion of empire?”

          “their own” sense of delusion? The US is the spearpoint of globalist business. These business interests used England for their expansion and the 20th century used the USA. “We The People”, the codified masters of the USA, aren’t calling the shots but pay the price for those that do.

        • rellik says:

          TB,
          I really resist calling America an empire in the classical sense. We have this annoying habit of kicking butt and then giving it all back to them. We even did this in our own civil war. Our system is weak because we allow idiots(Democrats) the right to gain power and dictate to the smart people, when we smart people should be dictating to them. That is what will destroy America. We will not survive this problem. No society has.

          • We are part of the Globalist Empire. We do most of the fighting to sustain and expand the Empire. We also got stuck with the bill. And the Empire’s leaders destroyed every country they they invaded. And they destroyed ours, also.

          • Kevin2 says:

            Its not an American empire; its a globalist, internationalist business financial empire. In essence its global racketeering and the US is not the mafia, the US is the enforcer for the mafia.

            Major General US Marine Corps, Antiwar Activist : 1881-1940

            “I served in all commissioned ranks from second lieutenant to Major General. And during that period I spent most of my time being a high-class muscle man for Big Business, for Wall Street and for the bankers. In short, I was a racketeer for capitalism. I suspected I was just part of the racket all the time. Now I am sure of it.”
            Received 16 military medals, 5 for valor. Is one of 19 men to receive the Medal of Honor twice.
            Wrote the 1935 exposé that linked business and the military titled “War Is A Racket.”
            Ran for Senate as a Republican in 1932.

            • Kevin2 says:

              I suspected I was just part of a racket at the time. Now I am sure of it. Like all the members of the military profession, I never had a thought of my own until I left the service. My mental faculties remained in suspended animation while I obeyed the orders of higher-ups. This is typical with everyone in the military service.
              I helped make Mexico, especially Tampico, safe for American oil interests in 1914. I helped make Haiti and Cuba a decent place for the National City Bank boys to collect revenues in. I helped in the raping of half a dozen Central American republics for the benefits of Wall Street. The record of racketeering is long. I helped purify Nicaragua for the international banking house of Brown Brothers in 1909-1912 (where have I heard that name before?). I brought light to the Dominican Republic for American sugar interests in 1916. In China I helped to see to it that Standard Oil went its way unmolested.
              During those years, I had, as the boys in the back room would say, a swell racket. Looking back on it, I feel that I could have given Al Capone a few hints. The best he could do was to operate his racket in three districts. I operated on three continents.

  7. hey-who says:

    Well, this may just be the final straw that breaks the ape’s back…it will be extremely difficult to pay 3%+ Interest on the ridiculously crazy out of hand national debt…

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