BY FAR the biggest area I experience young investors having to "unlearn" is in the area of WACC & cost of equity. The orthodoxy that we teach finance students that CAPM will feed into WACC and provide an accurate assessment of cost of capital for publicly traded equities is just bad. There are so many reasons why. The silliest may be that in the development of CAPM in the 60's and 70's (initial paper 1964 with some follow-ups), beta showed a strong linear relationship with realized returns. The problem is, it hasn't since (see Betting Against Beta, or the low beta paradox). So basically a data mining error by a few academics in the 60's and 70's without robust theoretical intuition (or understanding of markets) has continued to serve as the foundation of how we think about cost of capital as investors, and help investment bankers continue to justify large and stupid M&A to corporate boards. Lol. The list goes one and on. In calculating WACC, investors had a risk-free question post GFC (do we use observed 0-0.5% risk free rates? But that implies 40x+ P/E on the S&P 500) and now we have a market risk premium issue (if we observe 4.5% risk free but believe markets are priced to 5-6% returns, MRP is only ~100bps, again implying a WACC of 5.2% / a market P/E of 37.6x...letalone using Goldman's latest forward market forecast of LSD or NEGATIVE MRP). The WACC formula is just clearly nonsensical and should be treated as a non-sensical formula. The most fundamental problem with the way investors are taught about cost of capital, however, is that it selected an erroneous driver in volatility and ignores the most critical input: valuation. This becomes a problem because many investors don't understand true economic cost of capital, but almost zero companies actually understand their true cost of capital. And in my journey as an investor, this lack of understanding leads to a lot of bad decision making (i.e. bad timing of share repurchase and value destructive M&A) To illustrate, if I hold the fundamental outlook for a typical company constant and flex my cost of equity, I can see how various cost of equity inputs flow through to an implied price to earnings ratio. Unlike the WACC assertion that higher volatility mathematically results in higher cost of capital (observably false across a cross section of equities), it is intuitive that higher valuations lead to lower cost of equity. This can be demonstrated most clearly by thinking about the share count dilution needed to raise $100m on my theoretical $2.5bn EV company. Why does this linear relationship matter? It is hugely important to understand this when it comes to the critical analyst responsibility of evaluating capital allocation & management behavior. Can Elon be accused of being too promotional and chronically missing targets at TSLA over the last 10 years? Sure. However, his ability to sell a vision and sell a narrative reflexively was critical to the ultimate success of TSLA. He was able to maximize market valuation which mathematically minimized the dilution (and kept capital window open) necessary to raise the billions of capital that were necessary to the survival of TSLA. Elon's promotional behavior was a rational management behavior. Any biotech investors know this to be true as well...sell the dream of the molecule or you will never be able to fund the Phase III. It is important, then, as investors in innovative, capital dependent businesses to understand this bias. On the flipside, many of the cash generating healthcare services companies I covered in my career were all too happy to keep expectations low and consistently buy back MSD/HSD of the share count each year (AmerisourceBergen comes to mind), turning MSD EBIT growth into low teens EPS CAGR and some very nice equity compounding (AZO another high profile story that followed this path). And on compressions in the P/E that implied expansion of cost of equity into the mid-teens or above, the best managers realized that and saw that share buy-back was their best & highest use of capital. (one of my all-time favorite set-ups...compounder with a temporary issue stepping up the buy-back). Remember this post the next time a 12x P/E company you cover tries to justify doing a mega-merger at a 7% WACC (because the bankers told them that's the WACC to use!), or tells you they don't want to buy back stock at 10x earnings because they aren't "market timers". As investors, we should spend more time trying to estimate True Equity Cost of Capital (TECC - has a nice ring to it). I'm not smart enough to put this into an academic formula to compete with WACC (and TECC as I calculate it below requires many simplifying assumptions), but the Fundamental Edge team is deepening our Evaluating Management curriculum that includes a deep dive on Capital Allocation, and this is an area we will be diving deeply into and thinking through more. Hope it's helpful!
