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Consilient Observer
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December 21, 2020

WACC and Vol

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December 21, 2020

WACC and Vol


Consilient Observer

WACC and Vol

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December 21, 2020

 
 

Valuation for Companies with Real Options

 
 
  • The weighted average cost of capital (WACC) and volatility (vol) generally move in rough lockstep, but 2020 is unusual because the cost of capital is well below its historical average and volatility is well above its historical average.
  • Businesses that have real option value benefit from a lower discount rate on their current operations and from the higher volatility of the options available to them.
  • In this report, we define real options, discuss what kinds of businesses are likely to have them, review the valuation implication of a particularly noteworthy set of conditions in 2020, and finish with a method to incorporate real options analysis into traditional valuation.
 
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DEFINITIONS OF TERMS

Free cash flow (FCF) is a measure of financial performance calculated as net operating profit after tax minus investment in growth. FCF represents the cash that a company is able generate after laying out the money required to maintain or expand its asset base.

The cost of capital is the rate at which you discount future cash flows in order to determine the value today. The weighted average cost of capital blends the opportunity cost of the sources of capital, typically debt or equity, with the relative contribution of those sources.

The discount rate is the rate at which you discount future cash flows in order to determine the value today.

The equity risk premium, also referred to as simply equity premium, is the excess return that investing in the stock market provides over a risk-free rate, such as the return from government treasury bonds. This excess return compensates investors for taking on the relatively higher risk of equity investing.

The risk-free rate is the theoretical interest rate that an investor can earn on an investment that carries zero risk.

The S&P 500® Index measures the performance of the large cap segment of the U.S. equities market, covering approximately 75% of the U.S. equities market. The Index includes 500 leading companies in leading industries of the U.S. economy.

Correlation is a statistical measure of how two variables move in relation to each other.

The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index. The Russell 3000® Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market. The Russell 3000 Index is constructed to provide a comprehensive, unbiased and stable barometer of the broad market and is completely reconstituted annually to ensure new and growing equities are reflected.

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