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The Weighted Average Cost Of Capital
This is a revisitation of a report I wrote back in late 2016, predicting the imminent end of zero-bound interest rates and warning of the downward pressure that rising rates, mathematically, must place on today’s elevated asset prices.
Since the publication of that report, interest rates have indeed vaulted higher. Look at how the 3-month US Treasury yield has exploded since the start of 2017:
A Little Background
When I was fresh out of college in the mid-90s, I landed a job at Merrill Lynch. I was an “investment banking analyst”, which meant I had no life outside of the office and hardly ever slept. I pretty much spoke, thought, and dreamed in Excel during those years.
Much of my time there was spent building valuation models. These complicated spreadsheets were used to provide an air of quantitative validation to the answers the senior bankers otherwise pulled out of their derrieres to questions like: Is the market under- or over-valuing this company? Can we defend the acquisition price we’re recommending for this M&A deal? What should we price this IPO at?
Back then, Wall Street still (mostly) believed that fundamentals mattered. And one of the most widely-accepted methods for fundamentally valuing a company is the Discounted Cash Flow (or “DCF”) method. I built a *lot* of DCF models back in those days.
I promise not to get too wonky here, but in a nutshell, the DCF approach projects out the future cash flows a company is expected to generate given its growth prospects, profit margins, capital expenditures, etc. And because a dollar today is worth more than a dollar tomorrow, it discounts the further-out projected cash flows more than the nearer-in ones. Add everything up, and the total you get is your answer to what the fair market value of the company is.
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