"you expect a premium over the risk free rate for an equity investment because of the risks involved, the question is how much and it's open to conjecture"
I dont reckon it is worth worrying about the exact figure for the wacc it is too complex and in anycase most analysts who use are completely wrong
why not just simplify the whole proces to risk free rate plus a stock premium eg 3.75% risk free + 7% equity premium
the cost of debt is about 8%
why not just say the discount rate is 10% and be done with it
any way here is something I have written on the calculation it is a "dummies" guide to valuing shares using a two stage model
enjoy...
Most companies go through a period of where they growth and period where they stop growing. Usually the growth period occurs when they have less competition and they may have first mover advantage. Eventually other competitors come into the market and the business becomes less profitable. To survive it would have to return the cost of capital. Business then have two periods a period where they grow and one where they stop growing
Stocks are valued on the basis of earning going forward. The two stage model values a company on the basis of future earnings and the nature of business. It therefore incorporates two calculations of future earnings one for the growth period and one for the no growth period or the residual period.
To do these calculations you need to know two things 1. what is the companies eps now and 2. how much debt the company is carrying in this case earnings = 92c debt = $15m number of shares = 79.9 m debt per share = 19c
you then have to make assumptions for the growth period and the residual period. For the growth period you need to make a forecast the the growth rate, the length of that growth period and discount rate for that period. When looking at forecasts for the growth rate you need to study the product, the actual business, its finances, the competition, the sector and the general economy. In our example we will use the following assumptions.
First stage growth rate 14% Second stage growth rate 6% When deciding on a discount rate you can use a complex formula called the weighted average cost of capital (WACC) or you can use a simplified version of wacc. The simplified version is just add a risk premium for investing in stocks to the banks risk free rate. Eg For the growth period Risk free rate = 5% Equity premium = 7% Risk free rate + equity premium = Discount rate (or wacc) 5% + 7% = 12%
The discount rates I will be using the will be First stage discount rate = 12% Second stage discount rate = 15%
When deciding on the length of the growth period I would suggest 10-15 years for great companies, one or two years for lousy companies and 5-7 years for anything half descent. In the example lets assume we have great company like woollies and use 10 years. Therefore Excess growth period = 10 years
Step 1 making a calculation of value for the growth period
Year Eps (gr =14%) Discounted eps (dr =12%) Year 1 1.049 0.936 Year 2 1.196 0.953 Year 3 1.363 0.970 Year 4 1.553 0.987 Year 5 1.771 1.005 Year 6 2.019 1.023 Year 7 2.302 1.041 Year 8 2.624 1.06 Year 9 2.991 1.079 Year 10 3.41 1.098 total 10.152
Step 1 - A The way to do this calculation is to work out what the eps will be using the initial earnings figure ie 92 c, the growth rate for the excess period ie 14% and the number of years. The formula is E*(1+ g1) n Or you could your texas solar calculator Key in 92c and hit PV Next key in the growth rate ie 14 and hit %i button Next key in the number of years ie say 5 then hit compute ieCPT and final value ie FV to get your eps figure eg $1.771
Step 1 -B After that you must discount that earnings figure for time and risk in this case by 12% The formula is
EPS (1 + d1) n
Or you could make life easy for yourself and use your calculator.
Key in 1.771 and this time hit final value FV Next key in the discount rate ie 12 and hit %i Finally hit compute ie CPT and the primary value key ie PV You should end up then with a discounted eps figure ie $1.005 Do that for all the other years in the growth period.
Step 1-C Stocks are valued on the basis of earnings going forward. The next thing you should do is add up the eps figures to get a value for the growth period ie $10.152
Step 2 calculating what the residual period is worth.
The formula is this -
[E*(1+ g1) n + 1] / (d2 g2) (1 + d1) n
or you could do it like this on texas instruments calculator
step 2A calculating final years earnings
E*(1+ g1) n + 1]
a)plug in the initial earnings figure eg .92 and hit PV b)plug in number of years of excess growth PLUS one ie 11 and hit N c) plug in the growth rate of earnings eg 14% and hit the %i button d) hit the compute button cpt and FV you should get 3.888
step 2B capitalising
Next capitalise this earnings figure by subtracting the growth rate for the residual period from the discount rate from the residual period Remember the company will have stopped growing at this point so the growth rate should negligible. In fact due to time factor the discount rate should be higher than the growth rate for this period In this case the discount is 15% and the growth rate is 6% 15%-6% = 9% the for formula is this [E*(1+ g1) n + 1] / (d2 g2)
or you could use your calculator Plug in earnings figure ie 3.888 and then hit the and plug in the rate you are going to capitalise your earning figure by ie .09 and hit = You should get 43.111111 Ie 3.88/.09 = 43.11111
Step 2C discounting the capitalised amount
Finally you should discount this figure using the original discount figure to give you a total for the residual period The formula looks like this [E*(1+ g1) n + 1] / (d2 g2) (1 + d1) n
on your calculator you would do this - Plug in 43.1111 then hit FV Next key in the discount rate ie 12 and hit %i The number of years ie 10 and hit N Final hit CPT and PV to get your value which is $13.88
Step 3 calculating total value (including debt)
Next add the residual period to your excess growth period
Residual period = $13.88 Growth period = $10.15
Total = $24.03
Step 4 taking out borrowed funds
After that strip out all the long term debt In this case the company had $15m worth of long term debt
