Reading: WACC for Listed Firms
So far, we have seen what the WACC is and how we use it in firm valuation. This section takes a brief look at how to estimate the WACC in practice.
2. Estimating the Cost of Equity
What we are ultimately looking for is a rule or expression to determine the discount rate k, appropriate for a given stock. Specifically, we are looking for an expression of the following form:
k = Risk-free rate + Risk premium
k = Risk-free rate + Compensation for risk × Risk of stock
k = Risk-free rate + Market risk premium × Risk of stock.
In words, the discount rate we want equals the sum of the risk-free rate (the discount rate appropriate for investments without risk) and a risk premium. And the risk premium can be written as the market's compensation for risk (how much additional return investors require for one unit of risk) times the risk of the asset in question.
The above relation is very general. The purpose of this chapter is to learn how to actually measure the risk of a given asset and the necessary risk premium. As it turns out, there are many different theories and practical rules that teach us how to do so. We will focus on one particular model, the so-called Capital Asset Pricing Model (CAPM). Then we will briefly look at an alternative model to obtain the cost of equity based on expected dividend payments.