The WACC, or Weighted Average Cost of Capital, is an enterprise level discount rate used in capitalizing debt-free income measures and in terminal value calculations for DCF methods. There is virtually no readily available market evidence regarding WACC. On the other hand, there is substantial relative and comparative information available regarding EBITDA multiples. This video post discusses how to convert a WACC, which most market participants and appraisers know little about, into an EBITDA multiple for a company based on its own unique circumstances. And, as promised, we do so in three easy steps.
Hello! What if we could turn something that’s complicated and few people have any market evidence or know very much about–weighted average cost of capital — a colleague of mine used to say that weighted average cost of capital is like a big dark room. Many go in, but few come out!
What if we could turn a WACC into an EBITDA multiple? That’s the topic of today’s Valuation Video.
We begin with a WACC. You can read on ChrisMercer.net and find posts that talk about how to develop weighted average cost of capital. But business appraisers and market participants do this all the time (create WACCs). We’re going to begin today with a WACC of 14%. That’s not an unusual WACC for a private company, but that’s the beginning point. How do we turn that WACC into an EBITDA multiple?
Now, this is not a valuation of any particular company, but it’s a hypothetical. And it’s for illustration purposes only. We begin with the WACC based upon analysis. The long-term growth rate is assumed to be 4%. That might be 2% to 5%, plus or minus a little bit. But in this case, it’s 4%. Market participants and business appraisers do this all the time (estimate long-term growth rates). Subtract that 4% from the WACC of 14% and we get 10%. This 10% is a debt-free net income or net cash flow capitalization rate. I don’t know about you, but I have no frame of reference for debt-free net income or net cash flow capitalization rates. So we want to do something with it.
Let’s do this in three easy steps.
Number one. We divided by 1 minus the tax rate. You’ve already assumed the tax rate in the development of WACC. So you’ve already got it in this case, 26%. So, (1 – 26%) divided into the 10% debt-free cap rate is 13.5%. That 13.5% is an EBIT or a pre-tax debt-free capitalization rate. I still don’t know too much about that cap rate. But we can convert that in Step 2 — by dividing into — 1 into an EBIT multiple of 7.4. Now, we’re all much more familiar with an EBIT multiple than a weighted average cost of capital, but we can go one step further in step number three. We divide by what I’m going to call an EBITDA factor. Every company has an EBITDA factor because it is the relationship between EBITDA and EBIT. There is market evidence about the EBITDA factor. And in fact, I’ll reference you to some in just a moment. But we divide the EBIT multiple by the EBITDA factor of 1.2 and we get an EBITDA multiple of 6.2. So we have converted — in three easy steps — a WACC of 14%, which we don’t know anything about and have no market evidence about — into, given them the specifics of our hypothetical company here, an EBITDA multiple of 6.2. Now, at least we have some frame of reference and market evidence to say if that EBITDA multiple is reasonable or not.
So in today’s Valuation Video, we have converted a weighted average cost of capital into an EBITDA multiple.
I would reference you to an article in the Business Valuation Review. You have the ability to download it on the blog. Also on the blog, I created a little card to show this method to make it just easy to remember. You can print that off or download it on ChrisMercer.net.
If you have found this to be interesting, I hope you’ll comment.
If you have questions, I hope you raise them at ChrisMercer.net or on LinkedIn.
I look forward to the conversation. Until the next Valuation Video, good day.