RTCrawford’s Weblog

Over the last several weeks, I’ve been asked about my calculations for Weighted Average Cost of Capital (WACC) and Cash Return on Invested Capital. At some point, I’ll run through the specific calculations and logic behind them. Until then, allow me to provide the calculations which appear on the spreadsheet used for equities analysis postings.

Cash Return on Invested Capital is the easiest:

Weighted Average Cost of Capital is more complex. Here are the cells as normally presented:

Here are the same cells with their equations:

In each case, they reference other cells, which are located elsewhere on the same sheet or on another sheet entirely. Under the Equity portion, the Opportunity Cost references “[SUMMARY.xlsm]Check!B5.” Here is the “Check” sheet as it normally appears:

Same sheet with its calculations:

In general, I do not factor in a stock’s beta, since the price volatility of the market price is a reflection of the market’s uncertainty and psychology about the stock, the economy, and the price of wedding dresses at Filene’s Basement. I will occasionally use beta when calculating the weighted average cost of capital portion of Earnings-Power Value. The reason behind that is beyond the scope of this posting.

As for the other equations, they reference this hidden portion of the spreadsheet:

I’ve been asked about breaking out WACC by debt types. My basic response is that this is factored in to the reported data by Morningstar, from whom I get my raw numbers.

I spoke about this with a VP of equities analyst working on Wallstreet (formerly with Merill and Piper and now at a firm that will remain nameless) about the Morningstar data. He viewed it as reliable and, when asked about the occasional discrepancies between it and the data reported elsewhere, indicated that, in his experience, this was attributable to Morningstar applying the appropriate weights to account for the diluting effects of preferred stock, bonds, etc. In other words, this is largely baked in … but not entirely.

With WACC, there are a host of issues concerning its calculation. The original Modigliani approach assumed no growth. This was updated to factor in predictable growth rates when seeking to determine the net present value effects of a firm’s capital structure on future earnings. By my count, there are no fewer than 15 different ways to calculate WACC. While I am an MBA, I am not a CPA or CFP or a Series 7, and while I have a perspective that I hope is worth reading, I tend to focus on firms possessing relatively simple capital structures — avoiding, as much as possible, the more complex offerings.

Why?

I wouldn’t buy a company with a complex pre-existing debt structure if planning to own it outright, and I don’t purchase part-ownership through equities investing using any other standard of purchase. Instead, beyond comprehensibility, I am looking for businesses that are within my zone of comfort, which have an evident mis-pricing by the market, where the company is generating significant cash flows (since this is what banker’s accept for deposit), and where there is evidence of competent management (an assessment I feel comfortable making, since I teach management leadership and strategy, among other subjects).

When encountering firms with junior and senior subordinated debt, derivatives, swaps, convertibles, external warrants of significant size, foreign currency obligations, options, or minority interests that make my prospective investment as a part owner uncertain or suspect, I move to the next stock on my list. I can do the math (I teach higher order statistics with my quality controls class) and I have the training to do the analysis. What I don’t have is the time or the desire, and I am perfectly happy to leave this to the experts in the investments community.

So, with stocks possessing little debt in their capital structure, what the purists may fault as imprecision ceases to represent a material consideration. This removes many “growth” stocks from my list of prospects, where significant financial leverage (debt) provides the catalyst for growth — what Carlton Sheets describes as achieving wealth with “other people’s money.” Leverage, however, is a two edged sword, which enhances profits and expedites losses. I’m willing to give up the incremental increase in profits provided by leverage for the comfort accompanying loss avoidance through minimal leverage.

At some point, leverage becomes akin to a skinny, light-weight child riding a teeter-totter with a fat kid. The scrawny child couldn’t achieve the same heights without the leverage provided by his larger companion, but, in doing so, he gives up control of his destiny and becomes a Blanch Dubois character, depending on the kindness of strangers. The larger participant on the teeter-totter can be a well-behaved ally or he can send his victim into orbit, slam him tail-first into the ground from a great height, or hold him hostage at an uncomfortable altitude while his bladder fills, his mother calls him to dinner, or the wooden seat becomes increasingly uncomfortable at an extreme incline. Like guns, teeter-totters can be used for fun, for sport, and for menace. Leverage is has the same properties, possessing both benefit and threat.

Finally, as for the source of my WACC calculations, please consult Copeland, Koller, and Murrin’s “Valuation, 3rd.” Joe Ponzio’s FWallStreet.com has an excellent treatment on the differences between ROIC and CROIC.

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