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WACC calculates the cost of how a company raises capital or funds, which can be from bonds, long-term debt, common stock, and preferred stock. WACC is often used as the hurdle rate that a company needs to earn from an investment or project. Returns below the hurdle rate or the cost of obtaining capital aren't worth pursuing. The expected future cash flows from an investment are discounted or reduced by the WACC to factor in the cost of achieving capital.
The sum of all future discounted flows is the company's present value. Professional business appraisers often include a terminal value at the end of the projected earnings period. While the typical forecast period is roughly five years, terminal value helps determine the return beyond the forecast period, which can be difficult to forecast that far out for many companies.
Terminal value is the stable growth rate that a company or investment should achieve in the long-term or beyond the forecast period. Some analysts might also apply discounts in DCF analysis for small-company risk, lack of liquidity , or shares representing a minority interest in the company. DCF is a blue-ribbon standard for valuing privately-held companies ; it can also be used as an acid test for publicly-traded stocks.
This is especially true of smaller, younger companies with high costs of capital, and uneven or uncertain earnings or cash flow. For example, let's do a simple DCF test to check whether Apple stock was fairly valued at a given point in time. In this case, DCF provides one indication that the market may be paying too high of a price for Apple common stock. Smart investors might look to other indicators, such as the inability to sustain cash flow growth rates in the future, for confirmation.
Doing just a few DCF calculations demonstrates the link between a company's cost of capital and its valuation. For large public companies such as Apple , the cost of capital tends to be somewhat stable. But for small companies, this cost can fluctuate significantly over economic and interest rate cycles. The higher a company's cost of capital, the lower its DCF valuation will be.
During the credit crunch of and , the cost of capital for the smallest public companies soared as banks tightened lending standards. If you are building a small company and hope to sell it one day, DCF valuation can help you focus on what is most important—generating steady growth on the bottom line. In many small companies, it's difficult to project cash flow or earnings years into the future , and this is especially true of companies with fluctuating earnings or exposure to economic cycles.
They don't provide all the answers, but they can give us ideas about what we should pay for our investments. The right approach might be to use a combination of valuation methods to evaluate stocks.
To be clear, none of them are perfect. If there were, we'd all get rich very quickly and easily. This is certainly not an exhaustive list, but here are some of the other popular valuation methods:. Dividend discount model : This type of model uses a stock's current dividend rate, estimated future dividend growth, and the company's cost of capital to estimate the stock's theoretical value. Using a dividend discount model can be a smart way to calculate the value of dividend-paying stocks and is especially useful if a stock's dividend is the primary reason you're interested in the stock.
But using this valuation method has some obvious and significant shortcomings since the percentages of profits that dividend stocks pay always vary. Future dividend payments or dividend growth is not guaranteed, and the cost of capital can be extremely difficult to accurately predict. Residual income model : This type of model values a company based on its estimated future income. Some companies don't have positive cash flows or earnings and don't pay dividends, so the discounted cash flow and dividend discount models don't work very well.
In these cases, the residual income model is best. Beyond these options, there is no shortage of other valuation methods , which is why, if you ask 10 different analysts what a particular stock is worth, you're likely to get 10 different answers. It may be fairly obvious by now what is the biggest weakness of the DCF valuation method: Look at all the assumptions! Neither can be predicted with a high level of accuracy, especially earnings growth this is why stock prices tend to move sharply in one direction or the other after earnings reports -- because investors are often surprised at the results.
However, the DCF method isn't without its merits. Using it, we can see how close a stock is trading to its assumed fair value.
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