Using CAPM and WACC for Stock Valuation: What Rate Should You Apply?
In the realm of investment analysis, determining the appropriate discount rate for valuing stocks is crucial. This article delves into the use of the Capital Asset Pricing Model (CAPM) and the Weighted Average Cost of Capital (WACC) for free cash flow (FCF) estimation. We'll explore the roles of CAPM and WACC in stock valuation and highlight their significance in investment analysis.Understanding CAPM and WACC in Stock Valuation
Before discussing how to choose the appropriate discount rate, it's essential to understand the key concepts involved:
Capital Asset Pricing Model (CAPM): A financial model that determines the expected return of an asset based on its beta and the expected market and risk-free returns. CAPM is primarily used to estimate the cost of equity. Weighted Average Cost of Capital (WACC): A financial metric that represents the average rate of return a company must earn on its capital structure. It takes into account the cost of both debt and equity.Choosing the Appropriate Discount Rate
The choice of which discount rate to use—CAPM or WACC—depends on whether you are valuing free cash flow to equity (FCFe) or free cash flow to the firm (FCFF).
Free Cash Flow to Equity (FCFe): The appropriate discount rate for FCFE is the cost of equity, which can be estimated using CAPM. CAPM is a component of WACC but can stand alone for valuing equity as it solely focuses on the cost of equity. To estimate FCFE: Discount FCFE at the cost of equity to determine the enterprise value and then subtract net debt and other non-operating liabilities to arrive at the equity value.
Free Cash Flow to the Firm (FCFF): The appropriate discount rate for FCFF is WACC as it accounts for both the cost of equity and the cost of debt. WACC reflects the average return required by both equity and debt holders, balancing the interests of both types of investors. To estimate FCFF: Discount FCFF at WACC to determine the enterprise value and then subtract net debt to arrive at the equity value.
Intuitive Understanding of WACC
To grasp the concept of WACC intuitively, let's consider a hypothetical example:
Imagine a company, Company X, which requires $1,000 to operate and is financed equally by debt and equity.
The company borrows $500 from lenders, who require a 10% return on their investment. Company X also takes $500 from shareholders, who require a 20% return on their investment. To satisfy both debt and equity holders, the company must generate a 15% return. This 15% is the weighted average cost of capital (WACC).WACC for AutoZone
For instance, let’s look at the WACC for AutoZone, the second-largest retailer of aftermarket automotive parts and accessories:
By understanding the WACC, investors can effectively assess the expected return on their investment, ensuring they align with the company’s overall required return.
Conclusion
To summarize, for valuing stocks, you should use CAPM to estimate the cost of equity (FCFe) and WACC to estimate free cash flow to the firm (FCFF). The choice of discount rate is crucial and depends on the type of cash flow being estimated. By understanding the distinction between CAPM and WACC, investors can make informed decisions in their investment analysis.