Which is multiplied when evaluating a company
WACC or APV?
Only by calculating the current value is it possible to compare different investments with one another (“Time Value of Money”). The capitalization factor takes on a risk and control function.
There are two possible solutions to choose from, which differ in terms of the (interest-related) tax savings:
- Either the calculation according to the WACC (Weighted Average Cost of Capital) approach, which we will discuss here,
- or those based on the APV (Adjusted Present Value) approach, which we will not discuss further, as it is hardly widespread in practice and is relatively more difficult to apply.
Both basically lead to the same result, but are used for different financing structures.
Calculation of the WACC
The WACC approach on which we rely is based on the weighted average cost of capital (WACC) and is widely used as a valuation method.
With this approach, the excess payments that are available to equity and debt capital providers are used as the basis for the assessment (cash flows before deduction of interest and amortization payments).
The WACC reflects the costs of the different sources of finance with their respective weighted proportions. The cost of debt is calculated after taxes, which already reflects the interest-related tax savings.
The costs of equity, in turn, can be determined using different approaches, usually with the addition of risk components or the calculation of the CAPM (Capital Asset Pricing Model) (see below).
Calculation of the cost of equity
With this approach, which is an alternative to CAPM (see below), risk premiums are estimated and added up. The basis of this approach is the risk-free interest rate.
This is derived from the yield on ten-year federal bonds and is -0.5% in our example.
Company-specific risks (business risks, financial risk, immobility surcharge), industry-specific risk parameters (competition, market and environmental influences) and risk-reducing factors such as currency risks and protection against inflation are added or taken into account.
An example calculation could look like this:
- Risk-free interest rate (basis: ten-year federal bond): -0.5%
- Business risks (product / cluster / personnel, etc.): 2.5%
- Financial risk (financial structure, debt financing): 2.0%
- Immobility surcharge (saleability): 3.0%
- Sector-specific risk surcharge (competition / economy): 3.5%
- Risk discounts (currency risks, protection against inflation): 0.0%
According to this calculation, the cost of equity would be 10.5%.
Calculation of the "CAPM" cost of equity approach
The CAPM model is criticized every now and then.
For example, it needs to be explained why the value of a company has grown by double-digit percentages in recent years simply because the underlying risk-free interest rate is much lower today.
In order to obtain a meaningful basis for valuation, the cost of capital should therefore be recorded in more detail and multiples of comparable companies should be considered more closely.
But it is still one of the simplest and most recognized models in company valuation.
- Multiplication of the market risk premium by the risk of the company.
- Then add it to the risk-free interest rate.
Derivation of the free cash flow (FCF)
The basis for calculating the company value using the discounted cash flow method is the operating free cash flow (oFCF), which is discounted using a mixed rate, the aforementioned WACC.
This operating free cash flow is calculated according to the following scheme (equity approach):
- Operating earnings before interest and taxes (EBIT)
- ./. Adjusted taxes on EBIT
- = Operating earnings before interest and after adjusted taxes (NOPLAT)
- + Depreciation
- + Increase (decrease) in provisions
- = Gross (operational) cash flow
- ./. Investments in fixed assets
- ./. Increase (+ decrease) in working capital
- = Operating Free Cash Flow (oFCF)
- The discounted cash flow method is widely recognized and intuitively understandable
- Based on cash flows, therefore less distortion due to different accounting than with profit-based approaches
- Ideal for use with positive free cash flow, stable growth and a balanced risk profile
- Problems with residual values (see capitalized earnings method)
- The application is not very meaningful for companies under development, which usually show negative free cash flows
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