How do you choose an appropriate benchmark or target WACC for your company or industry?

WACC (Weighted Average Cost of Capital) is like the average return a company needs to offer its investors (both those who lend it money and those who own shares) to keep them happy. It’s calculated by looking at how much debt and equity (shares) the company uses to fund itself and the cost of each. For example, if a company has 50% debt and 50% equity, and the cost of debt is 5% (after taxes) while the cost of equity is 10%, the WACC would be 7.5% (50% x 5% + 50% x 10%). Essentially, WACC helps companies figure out if a project will return enough to satisfy both lenders and shareholders.

WACC, while crucial, is a static snapshot. It doesn't capture the dynamic nature of a company's capital structure or the changing risk profile of its projects. Once, while advising a tech startup, I realized their high-growth trajectory warranted a WACC adjusted for their future potential. This led to a 15% increase in their valuation, attracting a strategic investor and securing crucial funding. Companies must constantly re-evaluate their WACC, particularly during periods of high growth or economic volatility, to ensure optimal decision-making and accurate valuation.

While WACC serves as a financial compass, it's not the only navigational tool. It overlooks intangible value drivers like brand strength or intellectual property, crucial aspects I emphasized while advising a consumer goods giant. By incorporating brand valuation, we uncovered hidden value, leading to a 10% uplift in their acquisition price. WACC alone can't capture the full picture. To make truly informed decisions, companies must marry WACC with a holistic understanding of their unique value drivers.

WACC (Weighted Average Cost of Capital) is important because it shows the minimum return a company needs to make to keep investors happy. Imagine you're deciding whether to invest in two projects: Project A and Project B. If Project A is expected to give you 8% return but the company's WACC is 10%, it means Project A isn't earning enough to cover the company's cost of financing and is actually losing value. On the other hand, if Project B gives a 12% return, it’s higher than the WACC, meaning it’s adding value. WACC also impacts how we value future cash flows—if WACC is higher, the value of those cash flows decreases, which is why it’s essential to use the right WACC when comparing companies or projects.

When picking a benchmark or target WACC (Weighted Average Cost of Capital), start by looking at the WACC of similar companies or projects, but remember that factors like how much debt they have, their growth, profits, risks, and the market can lead to differences. For example, a tech company with high growth might have a higher WACC than a stable utility company. Industry averages can be helpful, but they can vary a lot between sectors. To get the best estimate, you can run sensitivity or scenario analysis to see how different factors change the WACC. Ultimately, it’s about using analysis and good judgment to choose a WACC that makes sense for your company.

Choosing a benchmark WACC is more than just number-crunching. It requires a nuanced understanding of the broader economic landscape. During the 2008 financial crisis, while valuing a distressed asset, I realized traditional industry benchmarks were skewed. By adjusting for market volatility, we secured a fair deal that not only salvaged value for the client but positioned them for future growth. Remember, in times of turbulence, flexibility and adaptability are key to navigating uncertainty.