Introduction to Stock Valuation Part 3 – Discount Rates
Now we need to introduce discount rates: (A discount rates is an interest rate or fee charged, i.e. a cost)
As we mentioned in our previous article the company’s total value (Enterprise Value) consists of debt and equity. Each of these has a cost to obtain them. Let’s start with debt as it is the more common and easier to understand.
Debt to a company is the same as a mortgage or car loan to a consumer. Both have to pay principal and interest on the debt. For companies, interest debt is paid before taxes so it is considered a pre-tax cost (noted as we will make an adjustment for this later)
Equity has a cost as well. Think of it in this manner
You start a business and bring in a shareholder for say 25% of the value of the equity so you have some money to buy equipment with or pay salaries.
From the investors perspective the cost of equity can be thought of as the return they would expect to get by investing (buying stock) in the company. In the public markets an investor that buys a blue chip stock expects a lower but safer return than one that buys stock in a new technology company for example. The return would need to be higher (much) in the technology company to offset the risk involved.
If a company has preferred shares their cost is the dividend paid (expressed as a %)
Which has the better return?
5 Blue chip stocks that increase in price by 6%, 8%, 8%, 9% and 4% or
5 Technology companies that return %52, 18%, -22%, 76% and -100% (ie went bankrupt)
If you invested $1000 in each of the 10 companies above the 5 blue chips would have returned
$60 + $80 + $80 + $90 + $40 = $350 (or now be worth $5350)
The 5 Technology companies would have returned
$520 + $180 – $220 + $760 – $1000 = $240 (or now be worth $5240)
To calculate these rates we do the following:
Cost of Debt = (Interest paid / Value of the debt) * (1 – Tax Rate)
Cost of Preferred stock = Dividends paid / Price of Preferred stock
Cost of common equity = This is calculated using a formula that takes into consideration how the stock moves with the overall market, risk of equity over debt and other company specific risks. The formula looks like this but we won’t go any deeper at this point.
Cost of Equity (Ke) = Risk free rate + Beta * (Market Risk Premium) + Company Risks
We combine these costs to come up with a value we refer to as WACC or Weighted Average Cost of Capital. The WACC is simply a weighting of the debt and equity for the company times their respective costs. We use the WACC if we are valuing the company on an Enterprise basis or use just the Cost of Equity if we are valuing the equity directly.
It was important to review that information as now we have the pieces we need to start to do valuation. In the next article we will start to discuss Valuation Methods