Nowadays, an increasing number of companies are opting to stay private for longer, bypassing regulations and public stakeholders. While the total number of US companies continues to grow, the number of those traded on stock exchanges has fallen 45% since peaking 20 years ago. As reported by The Economist in 2017, the number of publicly listed companies was 3,671, down from 7,322 in 1996. Thus, private company valuation has risen to the forefront, especially since it is required for anything from potential acquisitions to corporate restructuring and financial reporting. Understanding how discount rates are estimated and their role in financial decisions is important to both private business owners/operators and investors/valuation professionals. Unlike public company valuation, private company valuation often lacks publicly available data. However, both types of valuation have something in common: usage of the discounted cash flow (DCF) analysis, which requires (1) estimation of future cash flows and (2) a discount rate.

This article focuses on best practices for estimating private company discount rates, or the weighted average cost of capital (WACC), drawing on my 12 years of experience performing private company valuations and various editions of Cost of Capital: Applications and Examples. The discussion begins with an overview of the DCF analysis and the WACC, followed by detailed instruction around the components of the WACC. While this article will cover WACC as taught in accounting classes and the CFA program, it will also demonstrate how best to handle challenges encountered in practice. Perhaps unsurprisingly, a lot of classroom rules break down in the real world. And, since variables for estimating WACC are not simply pulled from a database, much analysis and judgment is required.

Building a Discounted Cash Flow (DCF) Analysis

Perhaps the most basic and pervasive corporate finance concept is that of estimating the present value of expected cash flows related to projects, assets, or businesses. This is accomplished via a DCF analysis, which involves the following steps:

  1. Forecasting expected free cash flows over a projection period.
  2. Estimating a discount rate that accounts for the time value of money and the relative riskiness of the underlying cash flows.
  3. Calculating the present value of the estimated cash flows for each of the years in the projection period using the estimated discount rate.
  4. Estimating a terminal value for the expected cash flows beyond the projection period.

This piece will focus on the second step. However, to illustrate the relationship between expected cash flows and discount rate, consider the following. On one hand, a US Treasury bond requires a low rate to discount the expected future cash flows, given the highly predictable nature of the cash flows (virtually risk-free). On the other hand, a technology company with more volatile future cash flows would have a higher discount rate. While risk can be accounted for by adjusting expected cash flows, the most common way is by increasing the estimated discount rate for cash flows at higher risk.

Extensive analysis should support the discount rate in a DCF analysis, as inaccurate discount rates directly impact resulting valuation outputs and could lead to an inferior investment or the bypassing of a value-creating opportunity.

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Calculating the Discount Rate Using the Weighted Average Cost of Capital (WACC)

The WACC is a required component of a DCF valuation. Simplistically, a company has two primary sources of capital: (1) debt and (2) equity. The WACC is the weighted average of the expected returns required by the providers of these two capital sources. Note that the discount rate must match the intended recipients of the projected cash flows in the DCF. That is, if the cash flows are intended for all capital holders, the WACC is the appropriate discount rate. However, the cost of equity is the appropriate discount rate if cash flows to equity holders are projected.

In addition to being a critical input for a business valuation, the WACC serves as a basis of comparison to the return on invested capital (ROIC) of the business. A company generates value through growth if the ROIC exceeds the WACC, but destroys value if ROIC is below the WACC. This analysis can be used by management to focus its attention on profitability or growth to increase enterprise value.

The WACC Formula

Mathematically, the required return of each source of funding is multiplied by its respective weight in the company’s capital structure. The sum of the weighted components equals the WACC. The formula for WACC is as follows:

While the WACC formula is relatively straightforward, a lack of transparency renders estimating the various inputs more complicated for a private company. In the following sections, I will guide you through how to estimate each component of the formula, starting with the costs of debt and equity, and their respective weights. We’ll examine a sample company (Company XYZ) throughout the remainder of the article to demonstrate how to estimate the various components of a private company WACC.

Interested in learning how to calculate discount rates for privately-held companies? Read the full article here.

Estimating WACC for Private Company Valuation: A Tutorial was originally published in Toptal Publications on Medium, where people are continuing the conversation by highlighting and responding to this story.