Credit: Shutterstock photoFor more than half a decade weAAAve been managing money and writing articles as weAAAve always done. My discounted cash flow model's a bit different than most.
If youAAAve ever taken a finance class youAAAve learned that you use a companyAAAs weighted average cost of capital ( WACC ) as the discount rate when building a discounted cash flow (DCF) model. However, we almost always do away with making a company-specific estimate and use a consistent discount rate for all the companies we value.
To illustrate why letAAAs look at the consumer staples sector AAAAA Coca-Cola ( KO ) specifically. We recently wrote an article about why the consumer staples sector is overvalued so we will continue that theme by using Coca-Cola as an example to show some flaws in the textbook method for calculating a companyAAAs WACC.
Brief refresher on WACC
First letAAAs take a brief refresher course on calculating a companyAAAs cost of capital. The formula for WACC is a companyAAAs percentage equity financing times cost of equity plus percentage debt financing times cost of debt times one minus the company's tax rate (interest is tax deductible). The formula is usually written as: WACC = E/V*Re + D/V*Rd * ( 1 AAA Tc)
- E/V = percent equity financing.
- Re = cost of equity.
- D/V = percent debt financing.
- Rd = cost of debt.
- Tc = corporate tax rate.
Calculating a companyAAAs percentage of debt and equity financing is pretty easy. Just take the companyAAAs current market cap and add the book value of the companyAAAs long-term debt from its latest financial statements. Likewise, calculating the cost of debt is fairly straightforward as well. Take the company's interest expense from its latest 10-K and divide it by the average of this year and last yearAAAs long-term debt levels (yes, this will include some interest expense for short-term debt, but it is close enough for our purposes).
Calculating the cost of equity is usually done using the Capital Asset Pricing Model or CAPM. The formula for the cost of equity is the risk-free rate of return plus the stock priceAAAs beta times the market rate of return (minus the risk-free rate of return). Typically the 10-year Treasury bond (trading at 1.55% as of this writing) is used as the risk-free rate of return and the market rate of return is usually the long-term average annual return for the stock market. Depending on the time series and market index you chose, you will usually get around 9% AAA AA up to 12% AAAAA as the market rate of return. I prefer to use 10% as itAAAs roughly in the middle of the various long-term market averages.
Looking at Coca-Cola as an example
LetAAAs go through valuing Coca-Cola using a traditional DCF model. Coke has a market cap of $192.08 billion and total long-term debt of $31.08 billion yielding an enterprise value of $223.16 billion. Long-term debt for the previous year, fiscal year 2014, was $22.59 billion. Interest expense for fiscal year 2015 was $856 million. The company had
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Consumer staples sector is overvalued
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
