Stock Study for Kids: What is WACC? Let's Think About the 'Cost' of Raising Money for a Company

When you study stock investing,

ROIC

WACC

these two terms sometimes appear as a set.

In the previous article, we studied ROIC.

ROIC is

an indicator that looks at 'how efficiently a company turns the money it uses for business into profit.'

It was an indicator to see that.

So, where does a company get the money it uses for its business in the first place?

Sometimes they borrow money from a bank.

Sometimes they raise money from shareholders.

In other words, for a company to use money to conduct business,

a 'cost of raising money'

is incurred.

When thinking about that cost, what appears is

WACC.

This time, I will explain WACC as simply as possible.

What is WACC?

WACC is,

WACC is

It stands for "Weighted Average Cost of Capital".

In Japanese, it is called "Kaju Heikin Shihon Kosuto".

In English, it is known as the "Weighted Average Cost of Capital".

It is called the "Weighted Average Cost of Capital".

It is referred to as that.

Just looking at the name, it seems quite difficult, doesn't it?

But, roughly speaking,

it is a number that shows "on average, how much cost it takes for a company to raise money."

This is the most important point of WACC.

It costs money to raise money.

For example, suppose you are going to start a bakery.

To build the shop,

10 million yen

became necessary.

However, your own money is not enough.

So,

you decide to borrow 5 million yen from a bank

and raise 5 million yen from shareholders

to do so.

That is what you decided.

You have to pay interest on the 5 million yen borrowed from a bank.

For example, at 5% per year,

5 million yen × 5%

= 250,000 yen

is the amount.

In other words, a cost of 250,000 yen per year is incurred to borrow money from a bank.

So, is the 5 million yen collected from shareholders free?

Actually, that is not necessarily the case.

Shareholders think,

'Since I am providing money to this company, I want to expect a profit that matches it.'

they think.

From a shareholder's perspective,

'How much return can I expect instead of investing in this company?'

becomes important.

In this way,

there is a cost to money borrowed from banks.

There is also a cost to money collected from shareholders.

That is what it means.

WACC is the 'average price of money'

Broadly speaking, the ways a company collects money are,

There is 'debt'

and

'money from shareholders'.

And each has a cost.

For example,

suppose the

cost of debt is 4%

and the cost of equity is 8%.

If a company

is raising money with

50% debt

and 50% equity,

to simplify it,

4% × 50%

+

8% × 50%

= 6%.

This is the result.

In this way,

'the average cost calculated by considering the company's methods of raising money and their respective proportions'.

is WACC.

In actual calculations, it becomes more complex because factors like taxes are also considered.

However, for starters,

'the average cost for a company to raise money'

is enough to remember.

Thinking of ROIC and WACC as a Set

Here, the ROIC we studied last time comes into play.

ROIC was an indicator that looked at

'how much profit was generated from the money used for the business'.

On the other hand, WACC is an indicator that looks at

'how much cost was incurred to raise that money'.

In other words,

ROIC

= How much did we earn using the money?

WACC

= How much did it cost to raise that money?

This is the relationship.

By comparing these two,

we can see if the company is creating value.

Let's look at it in more detail.

You can think about whether a company is using its funds efficiently.

What happens if ROIC exceeds WACC?

For example,

ROIC: 10%

WACC: 6%

Let's assume this is the case.

The company is using money raised at an average cost of about 6% to generate a 10% profit.

To simplify,

10% - 6%

= 4%

There is a difference of 4%.

In this situation,

you can consider that the company is generating more profit than the cost of raising the funds.

It is possible that the company is increasing its corporate value by conducting its business.

Conversely, what if ROIC falls below WACC?

Well then,

ROIC: 4%

WACC: 6%

In this case,

the company is spending more to raise money than it is earning from its business.

WACC: 6%

What happens in that case?

The company is raising money at a cost of about 6%.

However, even when they use that money for their business, they are only generating about 4% in profit.

To simplify it,

4% - 6%

= -2%

is the result.

Of course, actual corporate analysis is more complex, but

'the profit generated from the business is smaller than the cost of raising the money'

is the state of affairs.

Therefore,

ROIC > WACC

is an important concept in corporate analysis.

Let's think about it using a school test

Let's think about WACC more simply.

Suppose that on a 100-point test,

'you pass if you get 80 points'

is what you are told.

If your score is,

90 points

is a passing grade.

However,

60 points

is a failing grade.

Using a similar way of thinking,

ROIC exceeds WACC

↓

Generating more profit than the cost of raising funds

ROIC is lower than WACC

↓

Not generating enough profit to cover the cost of raising funds

can be thought of in this way.

Of course, company analysis is not just a simple pass or fail.

But,

'Comparing ROIC and WACC'

is a concept that I think is easy to understand with this image.

Is a company with a low WACC a good company?

Caution is needed here as well.

'A company with a low WACC is a good company'

That is not necessarily the case.

For example,

Company A

WACC: 4%

ROIC: 5%

Company B

WACC: 7%

ROIC: 15%

Let's assume these are the figures.

Looking only at WACC, Company A seems better because it is lower.

However,

Company A generates 5% profit

Company B generates 15% profit

as they operate.

Furthermore,

Company A: ROIC 5% - WACC 4% = 1%

Company B: ROIC 15% - WACC 7% = 8%

This is the result.

In this way,

rather than looking at WACC alone,

Looking at the relationship with ROIC

is important.

Why does WACC differ from company to company?

WACC varies depending on the company.

One of the reasons for this is

'how much risk the company has'

.

For example, a company with a stable business and small fluctuations in performance has a different risk profile from the perspective of an investor compared to a company whose performance fluctuates significantly.

If the risk is high,

'If I am going to invest in that company, I want a return that matches that risk'

is what more investors will think.

As a result, the cost of equity may also increase.

Also, interest rates on debt change depending on the company's creditworthiness and other factors.

In other words,

company stability

business risk

amount of debt

stock price

interest rates

and various other factors are involved in determining WACC.

Does a company with a lot of debt have a high WACC?

'A company with a lot of debt equals a high WACC'

is not something you can say simply.

Debt has a cost called interest.

On the other hand, because debt has tax advantages, the impact of taxes is also considered in the WACC calculation.

Also, if there is too much debt,

'Can this company really pay back its debt?'

is how it might be viewed by financial institutions and investors.

Therefore, it is important to check not just the amount of debt, but also:

How much profit is being generated

How the cash flow is doing

What the equity ratio is

How much interest-bearing debt there is

and other factors together.

When looking at WACC, try to understand the 'meaning of the numbers'

WACC is a very useful concept for company analysis, but you cannot understand everything just by looking at the numbers.

For example,

WACC: 5%

even if you only look at that number,

'Good'

It cannot be judged as

'bad'.

What is important is

ROIC: 10%

WACC: 5%

or

ROIC: 4%

WACC: 5%

the relationship between these two.

In other words,

'What is the WACC percentage?'

is not the only thing,

'How does it compare to ROIC?'

is what is important to look at.

ROIC, WACC, and Corporate Value

As you study the relationship between ROIC and WACC further,

it leads to the concept of

'corporate value'.

When a company

uses the money it has raised,

Generate profits that exceed the cost of raising that money.

If this can be continued over the long term,

it can be considered that

'this company is using its capital well to grow'.

Conversely,

if a state where profits cannot be generated that exceed the cost of raising money continues,

there is a possibility that

'the money raised with such effort is not being fully utilized'.

That is precisely why the relationship between ROIC and WACC is important when considering corporate value.

Summary of today

WACC is

'the average cost required for a company to raise money'.

It is.

Companies

borrow money from banks,

or raise money from shareholders,

to conduct business.

And both types of money have costs.

WACC is about considering that average cost.

And when thought of as a set with the ROIC we studied last time,

ROIC

= How much profit was generated using the money raised?

WACC

= How much did it cost to raise that money?

This is what it means.

What you especially want to remember is

ROIC > WACC

the relationship of.

In this state,

'The business is generating more profit than the cost of raising funds'

can be considered.

However, you cannot judge whether a company is good or bad based solely on ROIC or WACC.

Sales

Operating profit

Operating profit margin

ROE

ROA

Equity ratio

Interest-bearing debt

Free cash flow

It is important to look at it in combination with the numbers we have studied so far.

Instead of looking at just one number,

Think, 'How are this number and that number connected?'

That is what makes company analysis gradually more interesting.

WACC was a slightly difficult indicator this time, but

it is fine if you just remember that 'it costs money for a company to raise funds.'

ROIC and WACC.

By looking at these two as a set,

you will be able to view companies from the perspective of 'Is this company using the money it raised well?'

This will allow you to see companies from that perspective.

Thank you for reading.

Keep learning and enjoy the process!

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