How do you test the sensitivity and robustness of your valuation results using WACC and cost of equity?

Valued your company? Great! But is that number more solid than a sandcastle, or a rock? Time to play "WACC whack-a-mole"! Bump up your discount rate (WACC) and cost of equity – see how much your valuation shrinks. Watch it crumble like a stale cookie! Then crank them down – does your company's worth magically inflate like a birthday balloon? This isn't voodoo, it's sensitivity analysis! It shows how much your fancy valuation can wiggle based on these key ingredients. So play around, have fun, and don't be surprised if the results are a little... surprising.

Beyond mere calculations, WACC and cost of equity are intertwined with investor psychology and market sentiment. A company's narrative and strategic vision can powerfully sway these metrics, even surpassing purely financial factors. By crafting a compelling story and consistently delivering on promises, leaders can enhance their company's appeal, potentially lowering the cost of capital and unlocking greater value.

While CAPM provides a structured framework for estimating the cost of equity, it's crucial to remember that it relies on assumptions about market efficiency and investor rationality, which may not always hold true. Moreover, estimating beta and the market risk premium involves inherent uncertainties. To overcome these limitations, I often employ a multi-faceted approach that incorporates CAPM alongside other valuation techniques, such as discounted cash flow (DCF) analysis and comparable company analysis, to arrive at a more robust and reliable estimate of a company's cost of capital.

I used the Monte Carlo simulation to test the WACC, the cost of equity, and how it affects the value. This method is effective as it not only examines the sensitivity of the discount rate (denominator) but it can also considers the sensitivity of the economic benefit (numerator). It is a powerful tool to be considered.

While sensitivity analysis using WACC and cost of equity provides a valuable lens into potential valuation outcomes, it's essential to consider the dynamic interplay between these factors and the overall economic landscape. By integrating macroeconomic forecasting models with scenario analysis, we can gain a more nuanced understanding of how market shifts could impact a company's valuation beyond just simple percentage adjustments.

I may not consider other sources for every component of the WACC, as it seems odd to me as a practitioner. However, I can contemplate using different capital structures to test the optimal debt-equity ratio. This number could be useful for valuation.

Beyond testing robustness by varying inputs, true valuation strength lies in understanding the narrative behind the numbers. Once, I advised a tech startup where traditional models undervalued its potential. By incorporating the company's disruptive innovation and growth trajectory into the valuation framework, we secured funding that fueled their expansion. This experience underscores that while technical proficiency is vital, the ability to weave a compelling story around the numbers is what truly sets a valuation leader apart.

One of the benefits I can think of is that it demonstrates the valuer's consideration of how changes in key inputs impact the overall valuation. Sensitivity testing can also provide an additional layer of scrutiny.

Some practitioners I have observed perform sensitivity analysis by developing scenarios, such as optimistic, pessimistic, and most likely scenarios. In my view, there is no limit to how the valuer should or should not present their sensitivity testing, as long as they can demonstrate that they have considered how changes in key inputs impact the overall valuation.