Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) is a financial ratio that represents a firm’s average after-tax cost of capital in all resources, including common stock, preferred stock, bonds, and any other long-term debt. 

More specifically, it evaluates the company’s weighted average cost of borrowing money or raising funds and the cost of debt based on the company’s current capital structure. WACC ratio displays the number of funds the company pays for the operations either by utilizing one of equity or debts financing or the combination of both.

A lower WACC denotes that a company is in a position of producing sufficient income to pay for its overload debts, which indicates the sign of generating a high return to investors. In other words, the lower WACC of your company, the higher valuation in the market.

On the contrary, a higher WACC denotes that a company experiences a higher debt burden on raising capital, which decreases the company’s overall valuation and returns on investment for investors. A higher WACC is also associated with a greater level of risk.

WACC = Cost of Equity * % Equity + Cost of Debt * % Debt * (1 -Tax Rate) + Cost of Preferred Stock * % Preferred Stock

Here is a link for quick calculation:

https://fairness-finance.com/fairness-finance/finance/calculator/wacc.dhtml

Different type of companies might have difference WACC valuations, particularly for SaaS companies and Product Sale companies. SaaS companies have much higher company valuation driven by its recurring revenue and faster growth than the product sale companies.

Why do we calculate WACC?

One of the main uses of WACC is to aid in investment decisions. WACC is used as the discount rate when conducting a discounted cash flow analysis in order to calculate the Net Present Value (NPV) of an investment. Investors may look at a company's WACC when deciding whether or not to invest in a company.

In simple terms, WACC is the minimum acceptable rate of return at which a company yields returns for its investors. To determine an investor’s personal returns on an investment in a company, one must simply subtract the WACC from the company’s returns percentage.

Link for understanding the maximization of company valuation for SaaS companies:

https://www.opexengine.com/balancing-saas-growth-and-profits-to-maximize-saas-company-valuation/

https://austindalegroup.com/why-the-saascloud-business-model-drives-higher-valuations/