What is WACC?

A company is funded by two kinds of investors: shareholders, who take on more risk and expect a higher return for it, and lenders, who take on less risk and accept a lower, contractual interest rate in exchange. WACC blends the two costs together, weighted by how much of each the company actually uses, into a single rate. It answers the question: what return does this company need to earn on its capital just to satisfy both groups?

The two pieces

Cost of equity is estimated with CAPM: the risk-free rate (the yield on a safe government bond) plus the company's beta times the equity risk premium (the extra return investors demand for holding stocks over safe bonds in general). Beta measures how much the stock moves relative to the market — a figure best estimated bottom-up, from the unlevered risk of the industry the company competes in, then relevered to the company's own actual debt load, rather than taken at face value from a raw regression on a volatile stock's own price history.

Cost of debt is the rate the company would pay to borrow today, which can be read off an actual credit rating when one exists, or estimated from interest coverage (how many times over the company's operating income covers its interest expense) when it doesn't.

Putting them together

WACC weights the two by market value, not book value — how much the company's equity is actually worth at today's share price and how much debt it carries, not the historical accounting figures on the balance sheet. It also adjusts the cost of debt for the tax deductibility of interest, since interest payments reduce a company's tax bill in a way dividends don't.

Why it's the single most sensitive number in a DCF

WACC is the discount rate applied to every year of projected cash flow, and it also sets the denominator of the terminal value formula alongside the terminal growth rate. Because the gap between the discount rate and the terminal growth rate drives the terminal value, and the terminal value is usually most of a DCF's total value, a half-point change in WACC can move a fair value estimate far more than an equivalent change in almost any other assumption. It's worth checking this number specifically — and checking the beta and debt level behind it — before trusting any DCF output, including ours.

A company's WACC isn't assumed to stay fixed over an entire forecast either. A young or high-risk company's current WACC reflects its current risk profile; as it's assumed to mature, the model typically lets the discount rate glide toward a "stable company" WACC — a beta of 1 and an industry-typical debt mix — by the end of the explicit forecast.