Is WACC an appropriate rate for valuing companies like GS, LEH, FNM, etc? I am used to valuing companies with tangible products like phones, but the income structure of financial companies is throwing me off. If someone can point out any academic literature on this, that will be very welcome.
I think Virgin recommends some big number. Like infinity.
these companies are really being valued through the BS right now. additionally many of the Big banks are more about Div Disc model than earnings projections. ATBE though WACC would be calced with CAPM methodology.
The McKinsey book on valuation suggests using an equity discount rate and valuing cash flow to equity rather than using a WACC and valuing cash flow invested capital if valuing a financial institution. I am not sure how you would develop a WACC for a financial institution. Aren’t most banks/financial institutions valued using market multiples anyway?
Infinity is right. Don’t use the balance sheet, either. Remember, the accountants that audit the balance sheet don’t know how to value them. They have to model them cuz market price is illiquid (i.e. the market ain’t buying cuz the market ain’t stupid). Quick. How do you value the crap that Merrill just sold for 20 cents? Because it ain’t off their balance sheet. They loaned the buyer 75% of the money to buy the crap bonds. If the bonds are worse than they expected (of course they are) then there is no recourse to the buyer… back to Merrill they go. What the heck are the accountants going to say? SOme footnote somewhere if they’re lucky otherwise it just goes into liabilities. Just like that it’s not subprime debt anymore. It’s a secured loan Loan Star Hedge fund. So they pick up the phone and tell the SEC to stop traders who figured this shellgame out from shorting. That’s crazy. It can’t be that simple. Am I naive? i must be.
Well, ordinarily I’d say to “just use 10 percent” but with the credit crunch and all I would say 12.5% is probably warranted but you may want to stress test up to 15%. Though as Virgin pointed out Merrill, Lehman, etc. are just one big Subprime mortgage so you may want to use the all in yield on an A-rated CDO (Merrill still is A-rated, right?), so in that case like 42%. Yeah, yeah, yeah I know what Meredith Whitney said but when was the last time a A-rated company went bankrupt, March? That was MONTHS ago.
Heh, infinity. Actually since we’re in some kind of Bizarro World economically, it seems like it’s closer to zero…
I think that for Canadian financials you take the yield on the 5-year Canada and add 300 [may-be 500 now] basis points. For the US it’s their 5-year plus a Kagillion basis points. Willy
Thanks. Why am I not taking cost of debt into account, when banks raise money through the financial markets? OR is it that funding is usually short term, but assets are long-term, we don’t care about cost of debt?
The discount rate reflects the utility of the investor relative to other investments, not the company’s particular blended cost of capital.
(1+cost of equity)^leverage
WACC is probably fine if you know what the cash flows are going to be. The problem is that what the cash flows are going to be is anyone’s guess. Also, WACC is for activities that are in line with traditional business risks that the organization is experienced in managing. But this whole crisis in financials is all about the fact that none of these companies has any experience with the downside of the securitized turds they’ve all played with.