(LifeWire) - Most investors assess a stock's promise by weighing common-sense factors about the prospects of the company: the quality of its products or services, its future demand and the nature and strength of the competition.
But this qualitative analysis often fails to answer the critical question of valuation: Given the company's profit potential, is its stock a good investment at today's market price?
Professional stock analysts use models to estimate a company's inherent worth and to determine whether the company's stock is a bargain. These models require many inputs. One of the most important to consider is the company's weighted average cost of capital.
Companies are vehicles for the productive investment of capital. A typical clothing manufacturer, for instance, may use its cash to buy cotton, pay workers to sew the cotton into sweaters, and then pay a sales force to sell the sweaters for a profit. In this way, the company's ability to raise capital plays a crucial role in its ability to grow profitably.
Two Sources of Capital
Businesses can't mint money. One choice is to borrow money, either from a bank or through a bond sale. Another option is to sell a piece of the business through an offering of stock, or equity.
Both of these alternatives come at a cost. For debt, the company must make interest payments. For equity, it may make dividend payments, and shareholders will expect capital gains. The average of the costs of these two sources of capital, weighted for the proportion of each that the company uses to fund itself, is called the weighted average cost of capital. It is represented in the following formula:
r=wdrd(1-t) + were
According to this formula, the weighted average cost of capital, "r," equals the sum of the proportion of debt financing, "wd," multiplied by the cost of debt capital, "rd," and the proportion of equity financing, "we," multiplied by the cost of equity capital, "re." Because interest payments are tax deductible, the cost of debt is reduced by the company's tax rate, "t."
When a company's cost of capital rises, it becomes more difficult for it to profitably run its business.
Cost of Debt
The cost of debt is simply the cost of borrowing money, or the interest rate that the company would pay on the borrowed amount. When a company is considered risky, its cost of borrowing money rises, and when a company is considered stable, its cost of borrowing money falls. For companies that have issued bonds previously, it's possible to estimate the cost of debt by looking at the yield of those bonds.
The cost of debt explains the negative reaction that occurs when a company's bonds are downgraded by a ratings agency such as Standard & Poor's. With a lower rating, the company will have to pay higher interest to borrow capital, raising its overall cost of capital.
Cost of Equity
To estimate the cost of equity, consider the point of view of a prospective buyer of the company's shares. She will expect a return on the stock - from dividends and stock appreciation - and will not buy the shares if she does not believe she will receive that return, and will instead invest elsewhere. This expected return is the cost of equity.
To find the cost of equity, begin with the "risk-free" rate of return, or the gains that this theoretical investor could get by buying the safest investment around: a 10-year Treasury note. But the company that is issuing equity isn't risk-free - it has risks from its competition, from its industry, from its management team and from many other factors. This means that the investor will expect a premium above the risk-free rate; this is called the estimated equity risk premium.
Putting these factors together, we get the following equation:
re = rf + ß
The cost of equity, "re," equals the "risk-free" interest rate of a 10-year Treasury bond, "rf," plus the equity risk premium, "ß."
Finally, the investor will demand a greater return when the stock is very volatile, because she would prefer stability. So the stock's "beta" - a measure of its relative volatility - plays a role in calculating its cost of equity.