Estimating WACC for Private Company Valuation: A Guide

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The discount rate is a vital element of any discounted cash flow (DCF) valuation. However, when valuing a private company—one that lacks publicly traded equity or debt—determining an appropriate discount rate can be challenging. Unlike public companies, private entities do not have the same breadth of accessible data, making the estimation of a reasonable discount rate both art and science.

This guide focuses on best practices for estimating the weighted average cost of capital (WACC) when valuing a private company. It explains the foundational components of WACC, provides methods to estimate these components for private entities, and demonstrates its application through an example of valuing a private building materials company.

The Role of the Discount Rate in a DCF Analysis

A DCF analysis is a fundamental valuation tool in corporate finance that estimates the present value of future cash flows. At its core, a DCF analysis involves four key steps:

  1. Forecast Future Free Cash Flows: Project expected cash flows during a defined time period.
  2. Estimate a Discount Rate: Account for risk and the time value of money to discount those cash flows.
  3. Calculate Present Value (PV): Use the discount rate to determine the PV of projected cash flows.
  4. Estimate a Terminal Value: Assess the estimated value of cash flows beyond the projection period.

This guide focuses on step two—estimating the discount rate. The discount rate directly influences the valuation outcome, with lower rates increasing value and higher rates reducing it. Consequently, it’s crucial to calculate a discount rate that appropriately reflects the risk and return expectations of investors.

Calculating the Discount Rate Using WACC

The WACC is the most commonly used discount rate in DCF valuations. It represents the weighted average cost of a company’s two primary sources of capital: debt and equity. The WACC formula multiplies the required return of each funding source by its proportional weight in the company’s capital structure.

The WACC Formula

[
WACC = \left( \frac{E}{V} \cdot Re \right) + \left( \frac{D}{V} \cdot Rd \cdot (1 – Tc) \right)
]

Where:

  • (E): Total equity
  • (D): Total debt
  • (V): Total value of the business ((E + D))
  • (Re): Cost of equity
  • (Rd): Cost of debt
  • (Tc): Corporate tax rate

To ensure accurate valuation, the discount rate must align with the projected cash flows. For instance:

  • If cash flows are for all capital holders, use WACC.
  • If cash flows are equity-specific, use the cost of equity.

Example: Valuing a Private Company

Company Overview
Let’s consider a private US-based building materials company, “Company XYZ.” Critical background details include:

  • Revenue and profits are denominated in USD.
  • A blended tax rate of 26% applies.

To estimate WACC, we’ll calculate the cost of debt, cost of equity, and the optimal capital structure for the company.

Step 1: Estimating the Cost of Debt (Rd)

The cost of debt is the annual rate of return lenders require, typically based on the yield to maturity (YTM) of the company’s long-term debt. For private companies, estimating the cost of debt involves the following:

  1. Establish a credit rating: Analyze financial metrics (e.g., interest coverage) to determine an equivalent “synthetic” credit rating.
  2. Identify bond yields: Use relevant bond indices, such as the Moody’s Corporate Bond Index, to estimate YTM for companies with similar credit profiles.

For Company XYZ:

  • The estimated credit rating, based on interest coverage ratios (4.0–4.49), aligns with Moody’s Baa rating.
  • The corresponding YTM is 4.59%.
  • After adjusting for the 26% marginal tax rate, the after-tax cost of debt is:

[
4.59\% \cdot (1 – 0.26) = 3.40\%.
]

Step 2: Estimating the Cost of Equity (Re)

The cost of equity is the return required by equity investors, representing compensation for investment risk. The most widely used method to estimate (Re) is the Capital Asset Pricing Model (CAPM).

CAPM Formula

[
Re = Rf + \beta \cdot (Rm – Rf) + SP + CSP
]

Where:

  • (Rf): Risk-free rate (e.g., 20-year US Treasury yield).
  • (\beta): Firm’s sensitivity to market volatility (beta).
  • ((Rm – Rf)): Market equity risk premium (ERP).
  • (SP): Small stock premium (if applicable).
  • (CSP): Company-specific premium (if applicable).

Breaking Down the Inputs

  1. Risk-free Rate ((Rf)):
  • The YTM on 20-year US Treasuries is used as a proxy.
  • For XYZ, (Rf = 2.85\%).
  1. Beta ((\beta)):
  • Estimate beta using a comparable company set and unlevered betas.
  • Use the company’s target debt-to-equity structure to re-lever the beta.
  • For Company XYZ, beta is calculated within the range of 1.0–1.3.
  1. Equity Risk Premium (ERP):
  • Based on historical data and implied ERPs, an ERP of 5% is appropriate.
  1. Small Stock Premium ((SP)):
  • Given XYZ’s market size (\$475M), the chosen SP is 2.75%–3.75%.
  1. Company-Specific Premium ((CSP)):
  • No additional premium is applied due to lack of unique risks.

Cost of Equity for XYZ
[
Re = 2.85\% + \beta(5.0\%) + 3.25\% (\text{average SP value})
]
= 11.1%–13.35%.

Step 3: Determining the Capital Structure

For private companies, the capital structure is estimated based on those of peer firms or industry averages:

  • Industry average: Debt equals 15–20% of total capital.
  • XYZ capital structure:
  • 80–85% equity
  • 15–20% debt.

Step 4: Calculating WACC for XYZ

Using the WACC formula, we apply the calculated inputs:

  1. Cost of Debt ((Rd)) = 3.40%.
  2. Cost of Equity ((Re)) = 11.1%–13.35%.
  3. Capital Structure: Debt: 15%–20%; Equity: 80%–85%.

WACC Range for XYZ:
[
WACC = (E/V \cdot Re) + (D/V \cdot Rd \cdot (1 – Tc))
]
= 9.6%–11.8%.

Key Takeaways

  1. Judgment is Crucial: Estimating WACC for private companies requires qualitative judgment, especially when selecting peer companies and premiums.
  2. Precision is Limited: In practice, WACC is typically expressed as a range, reflecting the inherent uncertainty in estimating inputs.
  3. Customize for Context: Ensure that discount rates and valuation inputs align with the company’s operating environment, industry, and projected cash flows.

Accurate WACC estimation is vital for valuations or financial decision-making concerning private businesses. With an approach combining financial theory and real-world judgment, analysts can derive meaningful discount rates that reflect the unique risks and circumstances of privately held companies.

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