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Hello Hewitt,

I have a question about how you define WACC in your book. In Chapter 6: The Enterprising Income Statement, pg. 76, you show that the Equity portion of the weighting is derived from the Stockholder's Equity (directly from the balance sheet).

Other sources, such as Damodaran (Investment Valuation, 2nd ed), James English (Applied Equity Analysis), Investopedia (http://www.investopedia.com/terms/w/wacc.asp, etc.), all seem to be saying it should be derived using the market value of the equity (market cap).

It's a bit unclear if you're really saying something different, because in your example Wrigley has zero debt, so the calculation's "too easy", and maybe I'm missing your point.

I'm trying to understand which perspective makes the most sense. Stockholder's Equity makes the most sense, in that it's the capital that the company is using. It has no access to the "market value" of the equity. For instance, in an equity offering, the company sells shares at say $20 per share. 1 million shares = $20 million capital they get to work with. We should use this number to determine their "cost of capital" since they have no access to the extra cash in the market value, simply because the market bid the stock up to $24 per share.

Do you agree with this reasoning? Can you offer any insight into why the "party line" seems to be calculating off of market value?

I really appreciate any clarification.

Regards,
-joe
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Hey Joe...

I haven't read Mr. Heiserman's book yet (but it's on my short list), and I certainly cannot speak to his viewpoint... and as much as cost of capital caves my head in, I think I can at least point out why the general consensus is to use market value and not book value of equity.

As I understand it in general terms...

The arguments for using book value of equity are many... among them...

- it's easy to obtain straight off the balance sheet
- it has some tangible meaning, whereas market price is simply what's paid today
- if you use market value of equity to determine the debt/equity weighting to get your cost of capital... and then you use that cost of capital to determine your intrinsic value of the company... you're using the market value to determine an intrinsic value that may tell you the market value is wrong, meaning your intrinsic value is wrong since it was based in part on market value (wait... did I go around that circle too many times?)

So... given all this, how do you reconcile the contradiction between book value of equity and market value of equity, and why would you use market value? The bottom line (at least according to Damodaran) is that if you were to buy the entire company outright today, you'd have to pay market value for equity regardless of what shareholder equity on the balance sheet is. So, despite the convincing arguments above, you have to use market value of equity to determine intrinsic value.

He also points out an added bonus... you'll never have a negative market value for equity. Book value for equity can be negative. Good luck working with that.

That said, this is all purely academic in my (simple) mind. I may simply be too slow to calculate a useful beta, hence cost of equity is meaningless, hence weighted cost of capital is meaningless (to me)... so I use the often cited "hurdle rate" and focus my attention elsewhere in evaluating a company. I probably would fail out of business school though, so what do I know.

Anyway, hope that gives some food for thought... or at least a big fat grapefruit for someone more knowledgeable to shred apart while providing their own answer.

kevin
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Hey Kevin,

Thanks for the well thought out response. Yeah, CAPM makes my head hurt too, especially since beta's such a flawed concept.

The bottom line (at least according to Damodaran) is that if you were to buy the entire company outright today, you'd have to pay market value for equity regardless of what shareholder equity on the balance sheet is. So, despite the convincing arguments above, you have to use market value of equity to determine intrinsic value.

Hmm, I've heard that circular argument, but that sounds completely nonsensical to me. If I want to buy the whole company today, I have to pay X ... so, therefore, it must be *worth* X. Extrapolate that down to the per share level, and you have momentum investing :) Perhaps one wouldn't buy the company outright at today's price ... because it's overvalued.

I definitely get just using say, 11.5%, for a hurdle rate, and skipping the whole painful process. Perhaps I'm missing something, but while that seems to be sensible enough for a DCF cost-of-capital discount rate input, it seems to miss the point for my intended usage (which was only implicit in my earlier post).

I'm trying to get the cost of capital, so I can ding the company's NOPAT (or similar), implying that the capital they're using isn't free. And what I thought was nice about all this WACC business is that it would generate a different "interest rate" for their use of capital depending on the capital structure. So encouraging the company, if you will, to find the sweet spot of equity to debt that returns the greatest value.

By just plugging in a standard "hurdle rate" -- as in, I want at least this return to feel like I haven't wasted my time, considering the risk -- I've removed the whole capital structure nuance, and in theory the company should just take on lots more debt to increase their ROE, etc, because there's no penalty.

I'm not clear if I'm missing something, and should be happy with a hurdle rate for both usages, if I'm happy with it for DCF.

Best,
-joe
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Hi Joe...

If I want to buy the whole company today, I have to pay X ... so, therefore, it must be *worth* X. Extrapolate that down to the per share level, and you have momentum investing :) Perhaps one wouldn't buy the company outright at today's price ... because it's overvalued.

I don't think that's exactly the argument though. Remember... we're only discussing the market "value" for equity as opposed to the book "value" of equity. Your decision between the two only determines the debt/equity split to get the weighting used in cost of capital. Suppose the shares have been bid up to some astronomically high level... the only impact to your valuation by choosing market value of equity will be that cost of debt has effectively no weight in cost of capital. Since equity is more expensive than debt (for any realistically predictable company that a DCF is worthwhile for), an absurdly high market value for equity will actually give you a lower intrinsic value (than using book value for equity) for the company since you'll discount future cash at a higher rate. Assuming your hypothetically overvalued company trades at a p/b >> 1, using market value of equity will give you a lower intrinsic value than using book value, and therefore seems to be the more conservative approach.

So encouraging the company, if you will, to find the sweet spot of equity to debt that returns the greatest value.

This is an interesting conundrum in my opinion. A stable company with zero debt would mathmatically serve shareholders better by taking on some debt and returning the cash to shareholders if it didn't need to put it to use. However, there's a very real benefit, in my remedial opinion, to remaining debt free and having the headroom to weather a downturn, industry trouble, managment misstep, natural disaster, etc. Finding that sweet spot may optimize performance if everything stays the course, but that's rarely case. I think after watching a handful of debt-free companies lever up over the last year or so and then destroy their balance sheets when they hit a bump in the road, I'd prefer the headroom that comes from being debt free to a company in that sweetspot... even though a dcf will favor the opposite.

Oh well, enough rambling from me before I say more things that display how little I know. :(

kevin
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Kevin,

I don't think that's exactly the argument though. Remember... we're only discussing the market "value" for equity as opposed to the book "value" of equity. Your decision between the two only determines the debt/equity split to get the weighting used in cost of capital. Suppose the shares have been bid up to some astronomically high level... the only impact to your valuation by choosing market value of equity will be that cost of debt has effectively no weight in cost of capital. Since equity is more expensive than debt (for any realistically predictable company that a DCF is worthwhile for), an absurdly high market value for equity will actually give you a lower intrinsic value (than using book value for equity) for the company since you'll discount future cash at a higher rate. Assuming your hypothetically overvalued company trades at a p/b >> 1, using market value of equity will give you a lower intrinsic value than using book value, and therefore seems to be the more conservative approach.

I need to think about this a bit, but my initial reaction is moderate epiphany. Woohoo, I get it! This helps quite a bit.

Here's an interesting link re: the debt-to-equity sweet spot for adding most shareholder value:

http://www.investopedia.com/university/EVA/EVA4.asp

There's a little chart at the bottom that I found interesting.

I certainly hear you regarding debt on the balance sheet. I look at it a bit differently, though. Your view (albeit I realize it's only part of your view, and you were making a point) makes me think of how I feel about my mortgage. When I'm feeling financially vulnerable for any reason, my knee jerk thought is to pay down / pay off my mortgage. Safe, very safe.

But then I realize that my primary home mortgage, as long as the balance is reasonable to it's value (ahem, subprime, cough), and more importantly, the payments are *easily* within my wallet, then it is one of the few *very* sensible forms of personal debt. Much better than, say, renting for 30 years while saving the cash to buy a house outright when I'm 55 years old.

So, my point is that a company can not only use debt responsibly, it may in fact be irresponsible to ignore the option of using debt as *some* portion of invested capital, as long as the return on that capital is greater than it's cost, and by taking on some debt, that cost is reduced, since as you say, equity is more expensive.

Rambling now...

Later,
-joe
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Hi Joe...

So, my point is that a company can not only use debt responsibly, it may in fact be irresponsible to ignore the option of using debt as *some* portion of invested capital, as long as the return on that capital is greater than it's cost, and by taking on some debt, that cost is reduced, since as you say, equity is more expensive.

I don't disagree with this statement, and I think your home mortgage is a great analogy. I might not go so far as to say it's "irresponsible," but even that could be debated depending on the scenario. I said that I consider this tradeoff a conundrum, but that varies to some degree depending on the company I suppose. In the link you provide, for example, it's probably quite appropriate for Disney to use leverage and attempt to sit in that sweet spot seeing as they have a relatively predictable business at this point. Select Comfort, however, is an example of a company that levered up... put the proceeds into share repurchases between $15-20, and then the wheels fell off. Their balance sheet has deteriorated considerably, and they'd be in a much stronger position to weather their current trouble if they'd just stayed debt free. On the flip side, only time will tell, but it's my hunch (based on my own valuation) that Panera is going about it very appropriately. The debt they took on in November was used to repurchase shares at very good values in late December and early January... the debt load is modest, and they're able to easily service it while still funding growth with free cash. We'll know in a few years, but my opinion is that this was an opportune time for them to lever up, and given the uncertainty of a young, fast growing business like theirs, I'm glad they stayed out of the sweet-spot and maintained the debt-free balance sheet for the last nine years so they were able to take advantage of their current market valuation to return more capital to shareholders by taking on a modest amount of debt. They're still probably far from that sweet-spot, but it's too unpredictable of a business to be in I think, and their cash requirements are too significant to fully lever up today. The headroom is nice if we hit a prolonged slowdown.

Anyway... last post for the day... I spend too much time on the computer during the week to spend this much time prattling on over the weekend. :)

Later on...
kevin
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Kevin,
Select Comfort, however, is an example of a company that levered up... put the proceeds into share repurchases between $15-20, and then the wheels fell off. Their balance sheet has deteriorated considerably, and they'd be in a much stronger position to weather their current trouble if they'd just stayed debt free.

Ah, this is the crux of the matter - taking on debt wasn't in and of itself a bad move. It's what they used the debt proceeds for that was dumb. It was the spending, not the borrowing, that ruined their balance sheet. Granted, with SCSS you may say that if they weren't going to repurchase, then why borrow. Sure, but assuming a smarter management, with identifiable value-add opportunities, they could have perhaps put the debt to good use, thereby returning more value to shareholders by using cheaper capital.

-joe
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Try post 488:

My cost of equity assumption equals the 10-year Treasury yield plus 500 basis points. Studies show this spread approximates investor required rates of return over long periods. You can get Treasury yields going back to 1962 here: http://www.federalreserve.gov/releases/h15/data/b/tcm10y.txt.... But I always reserve the right to deviate from this rough cut estimate after studying the company, industry, competitive position, etc.


http://boards.fool.com/Message.asp?mid=23205260

MrT
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Hi MrT,

Thanks for the link. It helps, but I'm asking something different. Assuming I have a discount rate (Hewitt's 10 yr bond + 5%, for instance), I'm looking for the rationale behind determining the equity weighting vs. debt.

In the book, Hewitt uses the value of Stockholder's Equity, where literally every other publication I've seen uses current market value (market cap).

Regards
-joe
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Sorry -- replied without reading too closely.

I am with the party line on this one. You use the market value of the debt and equity just like one ought to mark up the enterprising capital to market.

The rationale as I believe already stated is that you use the market value because that is what you would have if you sold the equity to a third party in an arm's length transaction. (There are control issues that might demand a premium over a minority passive stake but that's getting beyond the point.)

Also if Wrigley was going to raise capital today in a secondary offering the price received would be near current levels -- considering dilution etc after the offering is placed. So if it wanted to raise capital via a stock offering it would receive ~$60 times the amount of shares sold minus the friction of the transaction.

Hope that didn't make things worse :)

MrT
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Joe, Kevin –

First, thanks for buying IETC. I hope the book helps you get a lot richer.

Second, if you or any other guests of this site want a copy of the presentation I gave at the Complete Growth Investor Las Vegas last October, please send me an e-mail at Hewitt.Heiserman@EarningsPower.com.

Third, before we jump into the mechanics of the enterprising income statement, let's take a moment to recall the question we are trying to answer: Is management creating value? We are not trying to determine if the company can pay its bills as it grows—that's the defensive income statement's job; and we are not trying to determine if the stock's price is compelling—that's valuation.

Okay, management creates value when they earn a return on capital that is greater than its cost. The two main sources of capital are debt and equity. As you know, you have book debt and book equity—these amounts are what you find on the balance sheet; and then you have market debt and market equity—this is what debt and stock trade for on the open market. Book values and markets values may or may not be the same.

When estimating capital, I use the book value of debt and equity. Book reflects how much money management has at its disposal to finance the asset side of the balance sheet, which in turn creates revenue and, hopefully, net income. Market values reflects the market's assessment of a variety of factors; e.g., does the company has defensive profits, is it creating value, are industry conditions attractive, are stock market conditions attractive, etc. etc. Management has little control over most of these factors, so it is not fair to judge them on events and conditions that are outside of their control, in my view.

Let me give an example. At year-end 2007, American Eagle had $838 million of operating leases, $110 million of senior liabilities, and $1.4 billion of book equity. Add these three sources of cash (there was no debt), subtract excess cash, and you get $1.9 billion. The market value of AEO's equity was $7.4 billion.

Now, a question. If you turned to the asset side of AEO's balance sheet, do you think operating assets are $1.9 billion? Or, do you think operating assets are $8.3 billion ($7.4 billion + $838 million + $110 million)?

If you said $1.9 billion, you are correct. Working capital assets include $(137) million of working capital [remember, we love negative WC—it's like having a job where you get paid today for work you will do in two weeks], $482 million of plant, property, and equipment, $838 million of capitalized leases, $453 million of operating cash [I discussed operating cash in an earlier post...maybe 12-18 months ago], and other assets of $298 million. Add it all up and you get $1.9 billion--the same $1.9 billion that we calculated from the right/bottom side of the balance sheet. Point is, management had $1.9 billion of assets to finance its income statement, not $8.3 billion.

To sum up, I use book values to estimate capital and the cost of capital. The reason is because we want to test whether management is earning a profit on the capital at their disposal. Market values, in contrast, overstate the amount of working capital and fixed capital that a firm employes to generate revenue and income.

Excellent question. If I did not answer your question adequately, please let me know.


Hewitt


Hewitt
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Hewitt,
Thanks for the detailed response.

Your explanation confirms my understanding - that we want to measure the company's ability to generate profits from the capital available to them. I was struggling with why I never see anyone else doing this, and I emailed Prof. Damodaran.

His response was that using book equity is appropriate for determining return on capital, whereas market equity is appropriate for determining cost of capital.

Is it reasonable to use market equity for the WACC - skewing the weighting such that it reflects if the company needed new capital - and book equity for the ROIC calculation?

So, ROIC = NOPAT / Invested Capital
where IC is very tied to book equity and Assets on the BS.

And WACC is derived using market equity.

Then EVA = ROIC - WACC.

It measures their current profits off their current available base, but granted, it then figures whether this is value-added by comparing to what equity would cost them today.

I'm not trying to use a microscope here - depending on the capital structure, this difference in weighting could be very minor - but I would like to have a good fundamental understanding before I start "swagging".

Thanks.
-joe
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Not sure that I have been helpful but hope springeth eternal.

One thing that hasn't been discussed much is the idea of book value compared to reproduction value. Reproduction value is estimated by its market value. (As a reference, Bruce Greenwald and his Value Investing book has done a good job of discussing this topic with real world examples.)

So:

If ROIC = WACC then book value should approximate reproduction value.
If ROIC < WACC then book value would be greater
If ROIC > WACC then market value would be greater

Now if in AEO's case, the market is assuming that the company is creating value and the operating profits of the company exceed the cost of the assets currently employed by the company (even after capitalizing operating leases). Or in terms of a multiple, to "own" the cash flow generation of AEO, one would have to pay over 2X the book value (which includes the debt equivalent of operating leases).

Consider a third party who wants to enter the apparel business. They can either start their own firm or buy AEO outright. Would someone be able to replicate AEO (and its profitability) with just the book value. I don't think so. Most likely they would have to spend at least @ 3.93B which is the company's current Enterprise Value. Given Hewitt's operating lease calculation of $838 million and the latest 10-Q, I get a very rough cut invested capital of $1.8 billion.

So to make the leap. If I was going to purchase AEO outright I would love to take it for $1.8 billion but the market would not let me and I would most likely have to settle for the current Enterprise Value. Next, I would have to determine how much equity I was going to use and therefore how much debt I was going to need to raise. Thus a target debt to equity ratio -- just like a LBO firm does, needs to be set based on the price I was going to pay to own (or at least partially own with the other sources of financing) the company.

And that target ratio is based on the market value of the firm not the original capital invested in the company that has been used to created the current value in the market place.

Interestingly enough that was one of the big drivers for LBO's were finding firms that they could recapitalize (ie push the debt level up) and profit from the additional leverage the firm was taking on.

Anyway, that's how I see it and why I would use market values to determine WACC.

MrT
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