Discounted Cash Flow (DCF) Valuation Basic – Part III

In previous articles, the basic concepts of DCF valuation such as time value money and FCFF were discussed (Read more here), and (Read more here).  This article will focus on basic concept of WACC and cost of equity, which are essential to “discount” the future FCFF stream to present value.

Some websites provide WACC and cost of equity for free, but the numbers provided by each site are slightly different.  This article will guide you to compute the WACC and cost of equity yourself. 

WACC is the cost of capital to run a company, which include debt and equity.  The formula of WACC is

where,

Debt      = market value of debt (or book value of debt)

Equity    = market value of equity (market cap)

kd           = Cost of Debt

ke           = Cost of Equity

Again, math is simple but getting the correct number to be inserted into the formula is not straight forward.  The following table shows the source to obtain the numbers and the level of difficulty to get them.

(for simplicity, kd is estimated using this year interest expense divided by average of this year and last year total debt)

CAPM is the most popular way to estimate cost of equity.  The formula of CAPM is

where,

Rf                          = Risk Free Rate (or Fixed Deposit rate for retail investor)

β                            = Beta (volatility of stock relative to overall market)

Rm                        = Market return

(Rm – Rf)             = Market Risk Premium

It is not easy to compute Beta but there are a lot of tutorials available on web or Youtube.  Fortunately, many financial websites are now publishing beta of company, but the issue is their numbers are different from each other.  This because each source is using different time horizon to calculate beta.  Some use 1-year, some use 3-year, and most of them do not state the time horizon explicitly.  Generally, those who do not state the time horizon highly likely are 3-year beta.

Market return, or more popular measure – “market risk premium” is also difficult to estimate.  Professor Damodaran from NYU Stern maintains a page to provide market risk premium for various country but only update occasionally for country outside US.  However, Malaysia investors can roughly estimate the market risk premium by using the implied ERP of S&P500 plus the yield spread between US T-Bill and Malaysia T-Bill.  Both data could be found in the Damodaran’s page and Bank Negara Malaysia website.

It is time to go for a real world example.  Again, we are going to compute Top Glove WACC.  The following table shows the respective data required to calculate WACC as at 9pm 18 November 2020.

Variables	Value	Source
Debt (FY2020)	RM0.54 bil	Top Glove Website
Equity (Market Cap)	RM59.0 bil	Bursa Market Place
Tax	17.4%	Top Glove Website
kd	2.3%	Top Glove Website
ke	9.88%	Compute
Rf	2.0%	Google FD Rate
[Rm – Rf]	6.85%	NYU & BNM
Beta (1-Yr)	1.15	TradingView
WACC	9.80%	Compute

The computed WACC is 9.80%  (WACC = 7.4% if 3-Yr Beta is used), which is higher than the numbers reported by some websites.  The main reason is we are using 1-Yr Beta (3-Yr Beta is around 0.8), which is highly volatile due to recent spike in prices.

We have covered three basic concepts of performing a DCF valuation, which are time value money, FCFF, and WACC (and cost of equity).  We will dive into the spreadsheet construction in the next article to estimate the value of Top Glove.

Stay online!  Stay safe!

Disclaimer:  The above analysis does not imply any buy or sell recommendation.  The author disclaims all liabilities arising from any use of the information contained in this article.

Disclosure: The author may have interest in the stocks of the companies in this article.