WACC, the most debatable topic in Finance

Any asset can be valued by discounting its future cash flow via a discount rate. This discount rate is called the weighted average cost of capital.

CAPM is not a good tool to calculate WACC

Most finance professionals have been taught to calculate the cost of equity using the Capital Asset Pricing Model (CAPM) and the cost of debt as a risk-free rate plus a credit spread.

Cost of equity = Risk-Free Rate + Beta X Market Risk Premium

Cost of debt = Risk-Free Rate + Credit spread

Terminal value = Free cash flow / (Cost of capital – growth)

Let’s assume free cash flow is 1000 and growth at 4% and see the difference.

Terminal value = 1000 / (8.5%-4%) = 22,222

Or

Terminal value = 1000 / (9%-4%) = 20,000

A difference of 2,222 can be huge, depending on the context.

We can see that relying on the capital asset pricing model is not wise. Rather than a precise number, even our ballpark number is good enough.

“Cost of capital is what could be produced by our 2nd best idea, and our best idea has to beat it.” – Warren Buffet

In the Indian context, our second-best alternative to equity is government security. However, we want to find out the cost of capital within the Equity group.

There are more than 6000 companies listed on NSE. However, all the companies are not the same.

“Think of three types of ‘savings accounts.’ The great one pays an extraordinarily high-interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will also be earned on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.” – Warren Buffet

Great business: High Return, High Growth

Example: Asian Paints, Nestle India

These businesses have a predictable cash flow. The risk attached to the cash flow is minimal.

Good business: High Return, Low Growth

Example: HDFC bank, HCL tech

These are good businesses, but cash flow growth is less predictable.

Gruesome business: Low Return, Low Growth

Example: Airtel, DLF

When you are investing your money, you should focus your efforts only on great and good businesses. Instead of using a capital asset pricing model, we can use a range-based cost of capital.

1. Equity returns: Since the weighted average cost of capital is a form of expected return, an easy way is to find out what has been the average expected return. The return would vary from the lowest category of risk to the highest category of risk. Please note that our definition of risk is only linked to the loss of capital and not to volatility.

A 10-year government bond security yield is around 7.5%, a large cap return is around 10%, a MidCap around 13% and a small cap around 15%. Even the most predictable cash flow-based equity will have some premium over a 10-year government bond yield so we can assign 7.5% +1.5% = 9%. So, the broad range is between 9 to 15%.

Depending upon the predictability of cash flow, you can assign the cost of equity. A feature of great business would be predictable cash flow, hence a lower cost of equity. Similarly, a good business with a less predictable cash flow may require a higher range of cost of equity.

2. Dividend-based approach: this is another approach to understanding the cost of equity. In simple terms, it is the dividend growth rate plus the expected GDP growth rate plus inflation.

An average dividend yield is around 1.5% plus the expected GDP growth of India is 6% plus the higher end of the inflation band which is 6% so the total is 13.5%.

Now the company may have an expected return growth rate of more or less than the GDP. For example, Colgate will have a lower GDP growth rate than India's GDP whereas CDSL may have a little higher GDP growth rate.

Another variation could be companies deriving their revenue from global markets. For example, the TCS growth rate can be associated with the global GDP growth rate. So, the adjustment should be done using the global GDP growth rate of around 3%. And in the global context the expected inflation is also less that is around two or 3%.

The capital structure may include debt as well. You can look at the recent borrowing by the company and use that as a proxy for the cost of debt. Apply relevant weights based on the capital structure and accordingly come out with the cost of capital.

It is better to be roughly right than precisely wrong. This is the reason using a range of cost of capital and applying that range to the company’s Cash flow is a better approach than using the capital asset pricing model.

When you are valuing a good or great company, one of the indicators of a good or a great company is a high return on invested capital. Value creation potential is linked with the difference between the return on capital and its cost of capital. A company generating a 30-35% kind of return on capital will not need a precise cost of capital number (9% vs 10%). Even if it is ballpark, you know that it will not meaningfully impact your assessment. This is the reason we call 'investing the last Liberal Art'.

In case you are looking at gruesome companies, the precise cost of capital is extremely important. Gruesome companies have a low return on capital. Even the most experienced investor cannot arrive at a precise cost of capital. Therefore, valuing a gruesome category of a company is speculative at best.

“It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books, so there’s a lot of twaddle and fuzzy concepts that have been introduced that don’t add much.” – Charlie Munger

Based on the quality of the business, a broad range of costs of capital can be worked out.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337

How to segregate your financial goals?

Each person has specific requirements and knowingly or unknowingly specific biases.

There are many ways to invest but you need to know your style

“Take up one idea. Make that one idea your life; dream of it; think of it; live on that idea. Let the brain, the body, muscles, nerves, and every part of your body be full of that idea, and just leave every other idea alone. This is the way to success, and this is the way great spiritual giants are produced.” - Indian Hindu philosopher and religious teacher

There are many ways you can invest. I chose a conservative style of investing. Since this is my style of investing, I apply the same to the investors. I have practised this style of investing for a decade now. I cannot point out a single source that has taught me this. It is a combination of extensive reading and self-reflection.

Over the last decade, I had an opportunity to interact with a variety of people. Working with individuals is unique, each person has specific requirements and knowingly or unknowingly specific biases.

Safety goals

To get rid of biases, I focus on areas that require little to no argument. Everyone has basic goals; I call these goals as safety goals. There is no argument that at one point people will retire, there is no argument that people want to save for their child’s future education, and there is also no argument that people want to buy at least one primary home.

At the portfolio level, an investor must allocate safe investments towards these goals. A combination of mutual funds, portfolio management schemes (PMS), new pension scheme (NPS), provident fund (PF) and public provident fund (PPF) helps in meeting safety goals. This way investors can create a conservative portfolio to meet their safety goals.

I also allocate to domestic and global equities as part of portfolio allocation. To meet safety goals, I prefer investing in companies that generate a high return, have minimal or no debt, and have a long history of creating shareholders’ wealth.

Comfort goals

Many people focus on money management to meet safety goals. However, India is changing, wealth creation is happening at a young age. So, working with a few founders helped me understand goals beyond basics. I called these goals ‘comfort goals’. Since these are investors' personal goals, there are natural biases. These goals are in the likes of travel, kids’ foreign education, moving into a bigger house et cetera.

As a priority, safety goals must be covered first. As far as safety goals are met, allocation towards comfort goals is advisable.

A combination of mutual funds, portfolio management schemes (PMS) and alternative investment funds (AIF) is suitable. I do not prefer taking debt allocation in the form of credit risk. However, a Short-term debt allocation or a conservative debt allocation using mutual funds is fine.

Similarly, a stock portfolio is created to meet comfort goals. The criteria of high returns and minimal or no debt continue. Instead of large global/domestic companies, market leaders in small and mid-caps are selected.

Luxury goals

An area which requires an extensive argument is the luxury category. These goals include buying a second home, extensive luxury travel, buying expensive cars, etc. This may require the person to invest in start-ups, private equity, land, crypto etc. Ideally, there should be no assets overlap between luxury and safety/comfort allocation. As a practice, I stay away from meeting luxury goals.

The idea of investing is first safety of capital and then growth. Avoid investments that are narrative-driven and not fundamentally driven.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337

Why equity investing can’t be taught but only learnt?

It is not unusual for investment professionals to get teaching assignments. I still remember I had the first assignment within a week of leaving corporate life. Since I came from a very sound corporate and educational background, I was well-received as an expert.

Why equity investing can’t be taught but only learnt?

I taught equity investing for almost around five years, and then I stopped. I felt equity investing is not about running a few screens or financial analysis of company statements but is way beyond. A lot of hard skills must be learnt over time and a lot of other mental models must naturally form interlinkages. These things can’t be taught in totality.

I am happy now as a student of investing, rather than being treated as a guru of investing.

There are two types of systems, a complex system, and a simple system. Let’s reflect on the simple system first. For example, self-interest.

Kar Bhalla to HO Bhalla

Adam Smith wrote a chapter on self-interest in the book Wealth of Nations. If people take care of themselves, they take care of others and ensure long-term sustainability. A mithaiwala who uses good quality products will continue to survive for generations.

Now let’s look at the complex system. A system that has too many moving parts is complex. Our body, life, relationships ..these are all complex systems.

It took me a while to understand that investing is also a complex system. A simple formula or financial model can’t indicate a good investment opportunity. If a complex model is created to identify a great opportunity, time will prove otherwise. There is no way you can understand complex systems in totality.

As a student of investing, I have concluded that there are so many equity investing styles that bracketing them all as one is not logical.

1. Price – Some investors believe the current price is the best reflection of value and place their bets accordingly.

2. Quality – Investors who invest in high-quality businesses available at a reasonable price.

3. Growth – Investors who are ready to pay any price for growth.

4. Value – These investors compare price and value, as far as there is a margin of safety, they will pick stocks.

5. Special situation – Mergers, acquisitions, spin-offs, demergers etc., create event-driven opportunities.

6. Regulatory play – There are a lot of investors who specialize in picking sectors/stocks based on regulatory advantages.

7. Cyclical – Commodities and financials are cyclical. Any bets placed during the right time can be high return-yielding.

8. Short-term growth movement – Short-term sales and profit growth can help in picking momentum stocks.

9. Clean accounting – Some investors prefer investing in companies with clean financial books and are ready to pay a premium for these companies.

The list continues including ESG-based investing, dividend stocks etc.

As an analyst, an interplay across these styles is very helpful. If you are so true to one style, you may ignore what other styles can offer. As a student of investing, you develop a deep understanding of 1-2 styles and acknowledge others.

A specific style can be taught in depth. For example, introduction to behavioural biases, valuation techniques, financial analysis, business strategy, financial history etc. However, creating interdisciplinary linkages is not where anyone can help. These mental models develop over time with practice.

A decade back I thought I know so much, today each day I have a feeling that I hardly know anything and a long way to go.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337