## Weighted Average Cost of Capital (WACC)

For the best financial analysis ratios, look no further. Harvard Business School and MIT Sloan empirically demonstrate the superiority of the data that drives our models and calculations. This paper compares our financial analysis to Bloomberg and Capital IQ (see appendix for details).

Weighted average cost of capital (WACC) is the weighted average of the costs of all external funding sources for a company.

WACC plays a key role in our economic earnings calculation. It is hard to be 100% certain about the exact cost of a company’s capital. Our guiding principle when calculating WACC is that it is better to be vaguely right than precisely wrong. We make sure that WACCs are reasonable first and employ many rules to normalize the inputs to WACC to ensure none of them cause an abnormal WACC to occur in any of our models.

The formula for WACC is in Figure 1.

**Figure 1: How To Calculate WACC**

** ****(Ke) * (E/TC) + (Kd * (1-T)) * (D/TC) + Kp * (P/TC)**

where:** **

Sources: New Constructs, LLC and company filings

Below we provide the details behind our WACC calculations.

**Cost of Equity**

- Our cost of equity calculation is based on the Capital Asset Pricing Model methodology.
- We use the market value of equity when calculating all Total Adjusted Market Capital ratios.
- The Equity Risk Premium is calculated as the average of the current implied Equity Risk Premium and the historical implied Equity Risk Premium.
- Though there are many other more complicated approaches for arriving at a firm’s cost of equity, we do not feel their additional complexity offers commensurate accuracy. CAPM is simple, gets us close enough and it is easy to implement consistently across all companies we analyze.
- For Beta, we use consistent values to avoid this variable having an inappropriately large impact on the WACC calculation. We apply industry and sector averages for beta to individual companies. Industry and sector averages are based on the actual individual company betas, which we calculate based on daily prices over the past 5 years. We assign the industry or sector averages where we see individual beta values clustered most uniformly within industries or sectors, respectively.

**Cost of Debt**

- The cost of debt capital should represent the business’ long-term marginal borrowing rate.
- The Risk-Free Rate (RFR) is approximated by the 5-year zero-coupon STRIPS.
- To the RFR, we add the debt spread associated with the debt rating on the company’s long-term debt.
- The resulting pre-tax cost of debt is then multiplied by (1 – marginal tax rate).
- We use debt ratings from Moody’s or S&P.

If a company fails to generate a return on invested capital (ROIC) greater than its WACC, it is destroying shareholder value. Figure 2 shows which companies have the highest and lowest WACCs.

**Figure 2: Companies With Highest/Lowest WACC as of April 8, 2016**

*Sources: New Constructs, LLC and company filings. *

Aradigm Corporation (ARDM) has the highest WACC of 3000+ companies under coverage. See ARDM’s historical WACC dating back to 1998 in our model here. The company has never earned a ROIC greater than WACC in any year of our model. As such, the company has generated negative economic earnings each year as well. WACCs affect on ARDM’s economic earnings can be seen in our reconciliation of GAAP net income to economic earnings here.

Neurocrine Biosciences (NBIX), Celldex Therapeutics (CLDX), Etsy (ETSY) and Halozyme Therapeutics (HALO) rank two through five in highest weighted average cost of capital.

Pepco Holdings (POM) has the lowest WACC of all companies under coverage. See POM’s historical WACC dating back to 1998 here. Over the past decade, Pepco’s ROIC has stagnated around a bottom quintile 3%. The last time Pepco earned a ROIC greater than WACC was 2001. AGL Resources (GAS), Consolidated Edison (ED), Dryships (DRYS), and Duke Energy (DUK) round out the list of lowest WACC across all companies under coverage. WACC’s affect on ED’s economic earnings can be seen here.

Our models and calculations are 100% transparent because we want our clients to know how much work we do to ensure we give them the best earnings quality and valuation models in the business.

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