What is a good WACC for startups?
As the risk of not achieving the expected earnings is relatively high for a startup (unless you have a stable business with positive financial results for a few years already) it's better to set your WACC higher than lower (> 25%).
In the above calculation, if we assume WACC < growth rate, then the value derived from the formula will be Negative. This is very difficult to digest as a high-growth company is now showing a negative terminal value because of the formula used.
- Step1: Estimating the Free cash flows to the firm (FCFF): ...
- Step 2: Estimate the discount rate or rate of return: ...
- Step 3: Estimate the terminal value: ...
- Step 4: Consider the case that startups may not be a going concern:
The various methods through which the value of a startup is determined include the (1) Berkus Approach, (2) Cost-To-Duplicate Approach, (3) Future Valuation Method, (4) the Market Multiple Approach, (5) the Risk Factor Summation Method, and (6) Discounted Cash Flow (DCF) Method.
When using a DCF analysis to value an M&A transaction, use the target company's WACC rather than that of the acquiring company. This is because the WACC of the target company will more accurately reflect the relevant risks inherent in the business being acquired.
As a rule of thumb, a good WACC is one that is in line with the sector average. When investors and lenders require a higher rate of return to finance a company it may indicate that they consider it riskier than the sector.
Warren Buffett however does not believe in WACC calculation. The statistical measures of risk such as beta or the CAPM model do not make much sense to him. He recommends using the long-term US government bond rates as appropriate discount rates for present value calculation.
To calculate WACC, one multiples the cost of equity by the % of equity in the company's capital structure, and adds to it the cost of debt multiplied by the % of debt on the company's structure.
According to the U.S. Small Business Administration, most microbusinesses cost around $3,000 to start, while most home-based franchises cost $2,000 to $5,000. While every type of business has its own financing needs, experts have some tips to help you figure out how much cash you'll require.
DCF for startups
As every valuation method based on the future, DCF values are dependent on the accuracy of forecasts. For early stage companies, with zero or no track record, and being likely to fail, these forecasts are usually far from accurate.
What does 10X revenue mean?
Put very simply, the 10X rule is taking any goal you've set for your company or sales team, and multiplying it by 10. So if a goal is to increase revenue by 5%, using the 10X rule, you'd increase that goal to 50%.
But what is a fair percentage for an investor? When it comes to angel investors, the general rule is to offer approximately 20-25% of your business earnings. If you're selling the business in its infancy, this is the amount that investors will expect in returns.
According to the data, the average successful startup has raised $41 million in venture capital and exited for $242.9 million dollars since 2007. Among those that were acquired, Crunchbase reports startups raised an average of $29.4 million and sold for $155.5 million.
WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight. Then, the products are added together to determine the value.
The Fed raised the discount rate to 0.5% in early 2022, and it will continue to make increases to move the inflation rate closer to its target of around 2%.
But the particular version of DCF that has been accepted as the standard over the past 20 years—using the weighted-average cost of capital (WACC) as the discount rate—is now obsolete. True, business schools and textbooks continue to teach the WACC approach.
A set of comparable companies and industry-level data was used to estimate a capital structure range of 15% to 20% debt to total capital. Step 4: Calculate WACC. Plugging these variables into the WACC formula, the estimated WACC range for the privately-held building materials company was 10% to 12%.
According to our estimate, Apple's WACC is 11.7%.
WACC Calculation
The WACC for Tesla Inc (NASDAQ:TSLA) is 8.67%.
A high WACC typically signals higher risk associated with a firm's operations because the company is paying more for the capital that investors have put into the company. In general, as the risk of an investment increases, investors demand an additional return to neutralize the additional risk.
Is a low WACC good?
An increasing WACC suggests that the company's valuation may be going down because it's using more debt and equity financing to operate. On the opposite side, a decreasing WACC shows the company is growing earnings and relying less on outside funding.
Using a discount rate WACC makes the present value of an investment appear higher than it really is. Obviously, then, using a discount rate > WACC makes the present value of an investment appear lower than it really is. So you have to use WACC if you want to calculate the merit of an investment.
It is essential to note that the lower the WACC, the higher the market value of the company – as you can see from the following simple example; when the WACC is 15%, the market value of the company is 667; and when the WACC falls to 10%, the market value of the company increases to 1,000.
REDUCING WACC
The most effective ways to reduce the WACC are to: (1) lower the cost of equity or (2) change the capital structure to include more debt. Since the cost of equity reflects the risk associated with generating future net cash flow, lowering the company's risk characteristics will also lower this cost.
Because WACC considers both debt and outstanding equity in a company, WACC cannot be zero. If a company holds zero debt, then its WACC will only be the measurement of its equity financing, using the capital asset pricing model.
using the wrong tax rate. using the book value of debt and equity instead of the correct valuation. assuming a capital structure that is neither the current nor forecasted structure. failure to satisfy the “time consistency formulae” (see the paper)
In theory, WACC represents the expense of raising one additional dollar of money. For example, a WACC of 5% means the company must pay an average of $0.05 to source an additional $1. This $0.05 may be the cost of interest on debt or the dividend/capital return required by private investors.
A set of comparable companies and industry-level data was used to estimate a capital structure range of 15% to 20% debt to total capital. Step 4: Calculate WACC. Plugging these variables into the WACC formula, the estimated WACC range for the privately-held building materials company was 10% to 12%.
According to our estimate, Apple's WACC is 11.7%.
In general, a higher WACC is a sign of a firm with higher risk, while a lower WACC is a sign of a firm with lower risk. This is because higher WACC's imply that the company is paying more to service any debt or equity they're raising.
Why is WACC important to investors?
The weighted average cost of capital (WACC) is an important financial precept that is widely used in financial circles to test whether a return on investment can exceed or meet an asset, project, or company's cost of invested capital (equity + debt).
Unfortunately, the WACC is flawed as the discount rate because it carries far too many false assumptions, relies on beta as a form of risk, and can be misleading due to the tax shield on the cost of debt. Individual/retail investors should therefore avoid using the WACC as their discount rate for valuation purposes.
Limitations of WACC
The WACC can be difficult to calculate if you're not familiar with all the inputs. Higher debt levels mean the investor or company will require higher WACCs. More-complex balance sheets, such as varying types of debt with various interest rates, make it more difficult to calculate WACC.
One alternative, called adjusted present value (APV), is especially versatile and reliable, and will replace WACC as the DCF methodology of choice among generalists.
The WACC is not suitable for accessing risky projects because to reflect the higher risk the cost of capital will be higher. Different people use different formulas to calculate WACC which gives different results and it also makes it difficult to accept WACC in some cases.
