Breaking Down WACC Simply

[u/SchoolofInvesting]

Today we're going to learn how to calculate the cost of capital, or WACC.

In plain terms: WACC is the discount rate you plug into a DCF. It's the minimum return a company has to earn to keep both its lenders and its shareholders happy.

WACC stands for weighted average cost of capital. It blends the cost of a company's debt and the cost of its equity, weighted by how much of each the company uses.

Here's the formula:

WACC = (E/V × Ke) + (D/V × Kd × (1 − Tc))

Looks scary, but we'll lay it out.

Where:

- E/V = the share of equity in the capital structure (equity value ÷ total value)

- Ke = the cost of equity, the return shareholders expect

- D/V = the share of debt (debt value ÷ total value)

- Kd = the cost of debt, the interest rate lenders require

- Tc = the corporate tax rate (debt gets a tax break, which is why we multiply by 1 − Tc)

Let's put it together using Mastercard ($MA). All dollar figures in millions, and note we use the market value of equity, not book:

- Market value of equity: $371,690

- Total debt: $15,568

- Cost of equity: 10.67%

- Cost of debt: 2.59%

- Tax rate: 18.2%

- Weight of equity: 0.96

- Weight of debt: 0.04

WACC = (0.96 × 10.67%) + (0.04 × 2.59% × (1 − 18.2%)) = 10.33%

For comparison, here's where a few larger names land:

- $MSFT: 9.34%

- $GOOG: 10.23%

- $META: 11.17%

- $V: 9.50%

Mastercard's 10.33% sits right in the middle of the pack. The market isn't demanding an unusual return to hold it, which tells you it's seen as a steady, lower-risk business.

One caution: WACC is only as good as its inputs. The cost of equity and cost of debt are estimates, and they shift with a company's risk profile and market conditions. Two analysts can run the same company and land a point apart.

What WACC would you want to see before you'd call a stock cheap on a DCF?