Value = Σ FCFₜ ÷ (1 + WACC)ᵗ + Terminal ValueA discount rate is just your next-best alternative with the risk priced in. If you would not accept the assumption on your own mortgage, do not accept it in a model.
WACC (Weighted Average Cost of Capital)
The blended price a company pays for the money it uses — part borrowed, part owned — and the hurdle its investments must clear to create value.
What is WACC (weighted average cost of capital)?
WACC is the blended cost of all the capital a company uses to finance itself — debt and equity — weighted by how much of each it employs. It represents the minimum return a company must earn to satisfy its investors, and in valuation it commonly serves as the discount rate in a DCF: the hurdle every project and reinvestment must clear to create value.
- It blends the cheaper, partly tax-deductible cost of debt with the higher cost of equity.
- A company creates value only when its returns (ROIC) exceed its WACC.
- WACC is an estimate built on contestable inputs, not an objective lookup value.
Definition
WACC is the average rate of return a company must pay its capital providers, weighted by how much of each kind of capital it uses. Debt holders are paid interest (cheaper, partly tax-deductible); equity holders expect higher returns for bearing more risk. WACC blends both into one number.
In valuation, WACC commonly serves as the discount rate in a DCF: it represents the minimum return that makes a company's cash flows worth funding.
Why it matters
A company creates value only when it earns returns above its WACC. Growth at returns below WACC actually destroys value — the business expands while each invested dollar earns less than it costs. Comparing ROIC against WACC is one of the fastest quality checks in fundamental analysis.
Simple example
A company is financed 40% with debt costing 5% after tax, and 60% with equity whose holders expect 10%. WACC = 0.4 × 5% + 0.6 × 10% = 8%. Any project, acquisition, or reinvestment that earns less than 8% makes the owners poorer, however impressive it looks on a press release.
Common misconception
"WACC is an objective fact you can look up." It is an estimate built on contestable inputs — especially the cost of equity, which depends on assumptions about risk. Two analysts will compute different WACCs for the same company. Treat it as a reasoned judgment with a sensitivity range, not a constant.
- 1It blends the cheaper, partly tax-deductible cost of debt with the higher cost of equity.
- 2A company creates value only when its returns (ROIC) exceed its WACC.
- 3WACC is an estimate built on contestable inputs, not an objective lookup value.
| Shortcut | The blended price a company pays for the money it uses — part borrowed, part owned — and the hurdle its investments must clear to create value. |
|---|---|
| Disciplined workflow | It blends the cheaper, partly tax-deductible cost of debt with the higher cost of equity. → A company creates value only when its returns (ROIC) exceed its WACC. → WACC is an estimate built on contestable inputs, not an objective lookup value. |
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Everyday example · The discount rate in your own life
You already use a hurdle rate — on your mortgage
Anyone deciding whether to repay a 5% mortgage early or invest the cash is already doing what a WACC calculation does: comparing a use of money against its next-best alternative. Repaying the loan "earns" a guaranteed 5%; any investment must clear that bar — adjusted for the fact that its return is not guaranteed — before it deserves the money instead.
Buffett and Munger run Berkshire the same way and famously compute no formal WACC. Their discount rate is opportunity cost: every project competes against simply buying more of the best business they already know at the current price. The arithmetic of WACC is a way of writing down that same question — what must this money beat? — not a magic constant to be copied from a textbook.
A discount rate is just your next-best alternative with the risk priced in. If you would not accept the assumption on your own mortgage, do not accept it in a model.
5%a mortgage = a risk-free hurdle
0formal WACCs used in Omaha
1question: what must this beat?
True story · The Nifty Fifty, 1972
When the price already assumed a miracle
In 1972, institutions convinced themselves that about fifty "one-decision" growth stocks could be bought at any price and never sold. Polaroid traded above 90 times earnings, McDonald's and Disney near 80, Avon around 65. Run the arithmetic backwards and those prices quietly assumed decades of flawless, ever-accelerating growth.
The 1973–74 bear market repriced the dream: the group fell 60–90%, and Polaroid eventually went bankrupt. The cruel detail is that many of the businesses kept growing exactly as promised — the investments still failed, because the starting price had already spent the future.
Run the DCF backwards: ask what growth today's price assumes, then ask honestly whether reality can deliver it.
90×Polaroid's P/E at the top
−60–90%drawdown in 1973–74
10+ yrsto recover, if ever
Related tools
Frequently asked questions
Should I always use WACC as my DCF discount rate?
WACC is conventional for valuing whole firms. Many value investors instead use a personal required return (e.g., 10%) for equity valuations — simpler and equally defensible if applied consistently.
Why is debt cheaper than equity?
Debt holders get paid first and have contractual claims, so they bear less risk and accept lower returns. Interest is also typically tax-deductible, lowering the effective cost further.
Estimate discount rates inside guided workflows:
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