WACC

One thing you must know if you want to estimate the intrinsic value of a company is the expected return on investment. To use a model on current value of future cash flows, you must have a discounting rate. One approach often used is the Weighted Average Cost of Capital (WACC). Basically, it looks at the capital structure of a company to determine the overall discount rate. That includes more than just the return on the common equity, but the return on other invested capital as well, most significant the debt (If one includes the value of all invested capital in valuation, it's also important to include interest payments as cash flow since this is a return for the debtholder). For example, a company that is financed by 50% debt and 50% equity capital and that has an expected return rate of 6% for the debt and 10% for the equity would have a WACC of 8%.

If you take this a step further, you could see how a company could have an optimal debt load. As more debt is added, the marginal rate for each new dollar of debt generally increases. At some point that marginal rate reaches the return necessary for the equity and that's where the debt load is optimal.

The return required for the equity usually depends on the beta, standard deviation or some other factors that consider risk.

My opinion of this is straight forward. First, in valuing a company, I'm interested in only the intrinsic value of the common equity and thus the only cash return of importance is that which flows to the common equity (that is, not interest, preferred dividends, etc.). Second, I think 'risk' for equity is not tied to any technical factor such as beta. Technical data that describe price fluctuation is not that important for me, since the only technical info I care about is the current price and whether it represents a discount or premium. More important is (1) what is the variation in the cash flow (the bigger the variation, the easier to err in valuing a company) and (2) what is the risk that my capital will be protected from loss. This second item is where debt comes in for me. Just as more subordinated debt carries a higher rate due to the higher risk, so too does equity carry a higher rate based on the amount of debt 'ahead of it in line'.

For example, take two companies of the same industry and size that should have the same return requirement for the capital. In fact, I would argue that theoretically both SHOULD have the same average rate of return regardless of capital structure. If A is 100% equity, it may have an 8% required return for that equity. If B is 50% debt, it may have a 6% return on debt and 10% on the equity. Again, what is not important is what the debtholders require, but what does matter is how much debt there is. The way I create a scale on this is thus: If I had $10,000 invested as debt in company A and I was the only debt and there was $10 billion in equity as well, I should probably expect no more that the treasury rate. My capital may be safer in that scenario that a treasury note. On the other hand if I owned all the equity $10K in company B and it had $10B in debt, I'd expect more or as much return as the most subordinate debt, which would be junk bond level. Usually your average case is somewhere in between. But when you buy debtless Google, you essentially have capital at both extremes and everywhere in the middle too. When you buy a debt-laden company, you still get the junk bond end and some portion of the middle of the continuum, but not the safe end. Those seats are taken.

Generally, I think 8% to 10% is a reasonable expectation for return in the safest companies and that rises maybe to the high teens for those companies that make you wonder how long it will be before bankruptcy wipes you out.