Weighted Average Cost of Capital (WACC) Case Study: Amazon (AMZN)
With a reach in e-commerce, cloud computing, digital streaming, and artificial intelligence, Amazon is now one of the largest corporations in the world. Analysts often refer to it as one of the most influential economic forces in the world. Alongside Google, Microsoft, and Apple, Amazon is considered one of the Big Four tech companies.
In this case study, we will calculate Amazon’s Weighted Average Cost of Capital (WACC), using comparable companies analysis.
Weighted Average Cost of Capital (WACC)
The WACC is an essential part of the Discounted Cash Flow (DCF) model, which makes it a vital concept, especially for finance professionals in business development and investment banking.
You can read more on the Weighted Average Cost of Capital in our dedicated article. It discusses WACC’s advantages and disadvantages and why a company needs to know its cost of capital.
Let’s look at the formula for the Weighted Average Cost of Capital:
- E is the market value of Equity;
- D is the market value of Debt;
- RE is the required rate of return on equity;
- RD is the cost of debt or the yield to maturity on existing debt;
- T is the applicable tax rate.
For this case study, we will simplify our approach and assume that Debt and Equity are the only two sources of capital for Amazon.
Comparable Companies Analysis
To perform a more detailed WACC calculation, we will look into Amazon’s main competitors. We will analyze their Beta coefficients, debt to market capitalization ratio, and average tax rates.
Let us start by looking into which companies are the competitors of Amazon. I started googling and came across an article on The Motley Fool listing the most significant competitors in different industries.
To keep it simple and limit the external tools we will use, let us only look at six of those companies, and exclude the ones with no tickers. We will perform our metrics review on those:
- Costco Wholesale (NASDAQ: COST)
- Target (NYSE: TGT)
- Alphabet (NASDAQ: GOOG)
- Microsoft (NASDAQ: MSFT)
- Netflix (NASDAQ: NFLX)
- Etsy (NASDAQ: ETSY)
The best place to source financial summary data for listed companies is Yahoo Finance.
Gathering the Data
Let’s start with Costco and look at the available data:
On the Summary page, we can see the Market Cap and the Beta (5Y Monthly). We will take the Beta from here but won’t use this market capitalization for our Debt to Market Cap ratio.
By switching to the Statistics page, we can get a market cap and debt balance as of the same date, while the summary page shows the market cap as of now.
From here, we get our Market Cap of $124.16 billion as of the last published report. A bit further down, we can find the Total Debt at the same time.
We take Total Debt from here, as most of these companies present short-term debt as part of current accrued liabilities, and we cannot take the actual debt balance from their balance sheet statements.
Now that we have our Beta and Debt to Market cap ratio, all we need is the tax average. As Yahoo Finance allows us to see the last four periods of a company’s financials without having a premium account, let us use a 4Y tax rate.
From the Financials page, in the Income Statement tab, we can locate Costco’s Income Before Tax and Income Tax Expense.
Taking the previous four periods and calculating an average tax rate, we get the following:
Now that we have Costco’s 5Y Beta, Total Debt, Market Cap, and Average Tax %, we can start building our comparable companies list:
Next, we go over our list of companies and gather the same information. After going through the data for each firm, we get the following summary:
You might notice that Etsy’s Average tax rate is 0%. We do this due to Etsy’s Income Statement showing tax reimbursements in a few of the prior periods. Therefore, I would go ahead and manually set their tax rate at 0% for the WACC calculation.
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Calculating Amazon’s Cost of Debt
Next, let’s calculate the cost of debt by looking into Amazon’s statistics on Yahoo Finance. They have a Debt balance of $77.5 billion and an interest expense of $1.6 billion in the financial year 2019. Dividing those gives us a 2.06% interest rate. Adjusting this with a tax shield, using the median of the average tax rate from the comparable companies, we get the following cost of debt:
Cost of Equity
To calculate the cost of equity we employ the Capital Asset Pricing Model (CAPM). The formula is as follows:
To find the risk-free rate, we will look into 10Y Treasury Bonds in the USA, as this is the market where Amazon mostly operates.
We can use google to find the latest rates. As of mid-April, 2020, the 10Y Government bonds have a yield of 0.76%.
For the Beta, we will use the median of our comparable companies, or 0.92.
The best resource for risk premiums is the Country Default Spreads and Risk Premiums page by Aswath Damodaran. Looking at it, we notice that we have a 6.01% equity risk premium for the US, and the country risk premium is at 0.00%. It is essential to see that there was an update of the risk premiums as of 1st of April, 2020, due to the massive impact of the global pandemic.
With these metrics, we can go ahead and prepare our cost of equity calculation:
Amazon’s Weighted Average Cost of Capital
Now that we have both the cost of debt and the cost of equity, we can calculate the WACC of Amazon. To do so, we first use the Total debt/Market cap ratio to calculate the weights of both components and weigh their impact on the calculation.
Following our calculations, we get a 6.30% WACC for Amazon. Keep in mind that there’s no way to tell how close this is to reality. Looking at other online sources, we can compare our results to those of other analysts.
If we take a look at Finbox we find they gave a lower, mid and upper estimations for Amazon’s Weighted Average Cost of Capital:
- WACC Lower — 7.90%;
- WACC Mid — 9.00%;
- WACC Upper — 10.20%
A bit above our predictions. However, if we inspect their model a bit further, we notice that they used a risk-free rate range of 3.50% — 4.00%. As we already noted above, due to the new global situation, the yield on 10Y US treasury bonds has fallen to 0.76% as of April 2020.
If you want, you can take a more detailed look at the formulas in the free Excel example, which you can download in the original article.
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Disclaimer: The information in this article is for educational purposes only and should not be treated as professional advice.
Originally posted on https://magnimetrics.com/ on 17 April 2020.