Our methodology combines the most advanced academic works and the business best-practices of cost-of-capital calculation. This state-of-the-art calculation combined with a rigorous data collection methodology allows great flexibility while maintaining consistency at each step.
We have defined an index (herein called the WACC Expert Index) composed of the world’s 1000 largest market capitalizations for which we monitor key performance and financial indicators such as historical market capitalization, free cash flow to equity, capital structure, earnings, consensus estimate…
Financial figures are obtained through a major data provider and are updated on a monthly basis.
Analysts typically use a sovereign debt yield as a risk-free rate. Few economies act as pertinent references for sovereign debt (meaning with regular issuance of new bonds, significant amount issued and price liquidity). To satisfy every user, it was important to let them choose their risk-free rate among those countries. We currently provide risk-free rates for the United States, Germany, United Kingdom and France.
Recent years have shown that the cost of borrowing for governments can be very volatile even on a daily basis. We let users adapt to market conditions and choose their favorite risk-free rate computation method: SPOT, 1-month average or 3-month average.
Risk-free rate compensates for:
Maturity risk is different for each investment and has a significant impact when it comes to investment decisions. We provide the choice between three different maturities: 2 years, 10 years and 30 years.
While Net Cash Flows are usually build in local currency, the risk free rate used to discount the Net Cash Flows should also cover the local currency risk. This is why we adjust the selected risk-free rate reference to take into account the inflation differential between the local currency and the currency of the selected risk-free rate.
Opportunity cost is not the same in low risk environment than in a high risk environment. Therefore we also adjust the selected risk-free rate reference to take into account the supplementary risks of the country in which Net Cash Flows are generated.
We estimate Country Risk Premium for any country by performing a regression of a wide list of countries credit ratings (Moody’s and Standard & Poor’s) on their respective CDS on senior 10-year complete restructuring sovereign debt in United States Dollar.
Finally the risk-free rate estimate is shown in the following formula:
where:
We estimate on a monthly basis the Implied Equity Return based on the WACC Expert Index (the world’s 1000 largest market capitalizations). As a sample of listed shares, this index is more representative of the global economy than any marketplace-based index and presents a balanced mix of companies from mature and emerging countries as well as of business activities.
We stand that the current market value of the WACC Expert Index equals the present value of the sum of the future free cash flows to equity (FCFE) from each of the WACC Expert Index companies, discounted at the Implied Equity Return.
This means that the Implied Equity Return can be estimated from the current market value of the WACC Expert Index and from the future cash flow to equity generated by the WACC Expert Index companies.
The future Free Cash Flows to equity are estimated in two steps:
We collect the consensus estimate (mean) on net income for the first 3 years (for the first two years, the mean is based on at least 5 estimates on more than 95% of the WACC Expert Index companies ; for the third year on at least 3 estimates on more than 95% of the base).
We calculate the ratio of the average Free Cash Flow to Equity to Net Income on the WACC Expert Index on the last 10 years (Free Cash Flow to Equity being the sum of the dividends paid to shareholders plus the repurchase or retirement of shares). On the WACC Expert Index on average, between 2004 and 2013, the Free Cash Flow to Equity represented 63% of the Net Income.
The conjunction of Net Income projections and of the average ratio of Free Cash Flow to Equity to Net Income determines the Future Cash Flow to Equity for the first 3 years.
Since the number of estimates rapidly decreases after three years using consensus estimate becomes irrelevant.
The long term stable growth rate of Free Cash Flow to Equity of the WACC Expert Index should be equal to the risk-free rate (which can be expressed as the sum of expected real growth rate and expected inflation).
Starting with the Net Income growth provided by the consensus estimate (year 2 and year 3), we use a linear interpolation from year 4 to year 10 in order to converge on the long term growth rate set to the selected risk-free rate.
Again we calculate the Free Cash Flow to Equity by applying the same ratio (of the average free cash flow to equity to net income on the WACC Expert Index on the last 10 years) to the Net Income projections.
Given the expected Free Cash Flow to Equity and current value of the WACC Expert Index we solve for the rate of return that is the Implied Equity Return (the return on equity investors need).
We subtract from the Implied Equity Return the selected risk-free rate to obtain the Equity Risk Premium (ERP).
We use a sectorial classification based on the Industry Classification Benchmark nineteen supersectors (ICB^{1}).
We use the WACC Expert Index to compute sectorial Betas. Working with the world’s largest companies ensures that all the companies used for beta calculation have a significant level of volatility and liquidity that are key prerequisites for beta relevancy.
We calculate the beta of each supersector as the regression of the return of the supersector (market capitalization of the supersector) on the return of the WACC Expert Index (2-year weekly beta).
Doing this brings a high level of consistency that is rarely observed in Beta estimation:
Finally, studies show that larger companies tend to benefit from a “size premium” that reduces their Beta. Based on several academic publications, we compute two adjustment coefficients that increase the Beta of mid-cap and small-cap companies respectively.
In the OECD economies, the best borrowers are usually governments or government-backed companies. Therefore, in a given country, the borrowing cost for corporations is usually floored by the reference risk-free rate of this economy.
This is why we build the corporate cost of debt as the estimated risk-free rate of the selected country plus a sectorial spread of debt
We calculate the ratio of Net Debt to Equity for any supersector as the ratio of the sum of the net debts of the WACC Expert Index companies from the selected supersector to the sum of the market value of equity of the companies from the selected supersector.
In addition, studies have demonstrated that access to debt is easier in developed economies: comparatively, debt levels are higher in developed countries than in emerging markets. Following those academic works, we adjust the above calculated gearing of the selected supersector with a coefficient calculated by WACC Expert to take into account less developed debt market in emerging countries
Offering maximum flexibility, we also allow registered users to marginally adjust the calculated ratio
We gather and update the marginal corporate tax rates for more than 100 countries.
We also included the option to manually fine-tune this proposed corporate tax rate to handle fiscal rules that apply on top of the default country marginal corporate tax rate to some specific businesses or company sizes.
^{1}The ICB system is supported by the ICB Database which is maintained by FTSE International Limited.