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Q: What Are the Six Tenets of Dow Theory?

1. The Market Discounts Everything, 2. There Are Three Kinds of Market Trends, 3. Primary Trends are Split into Three Phases, 4. Indices Must Confirm Each Other, 5. Volume Should Confirm the Price, and 6. Trends Persist Until there is a Clear Reversal.

Oct

2023

Dow Theory: 6 Principles Explained

By Laurel Tincher | Growing Wealth, invest, Investing | Comments Off

The Dow Theory is a framework for technical analysis of the market. It comprises several market concepts that attempt to explain how the stock market tends to behave.

The original financial theory posited that if the Dow Jones Industrial Average or the Dow Jones Transportation Average (then known as the Dow Jones Rail Average) advances significantly above a previous important average, the other average will do the same in the near future. Conversely, if one index begins to fall, Dow Theory forecasts that the other will likely follow suit.

Using this theory, investors can form a strategy to buy when the market is low and rising, and sell when it is high and going down.

The History of Dow Theory

Although created more than a century ago, Dow Theory remains popular with traders who commonly use it today. Charles H. Dow, founder of Dow Jones & Company, developed the financial theory in 1896 and created the first stock index, the Dow Jones Industrial Average. Dow, along with Charles Bergstresse and Edward Jones, also co-founded The Wall Street Journal, where Dow published portions of the Dow Theory.

Although Charles Dow died before he could publish the entirety of the ideas that make up the theory, others have published contributions to the theory over the years. Some of these publications include:

• The Stock Market Barometer by William P. Hamilton (1922)

• The Dow Theory by Robert Rhea (1932)

• How I Helped More than 10,000 Investors Profit in Stocks, by E. George Schaefer

• The Dow Theory Today, by Richard Russell (1961)

What Is Dow Theory?

The Dow Theory suggests that traders can use stock market trends to assess the overall economy and the state of various industries and then use it to form an investment strategy. Using the Dow theory, one could understand current market conditions and make predictions about the direction the market would take and, therefore, the direction individual stocks might take.

As the economy has changed over the years, parts of the theory have also shifted. For instance, originally, the theory centered around transportation stocks since the railroad industry was such a significant contributor to the economy at that time. While transportation stocks are still a crucial part of the economy, the Dow theory can apply to all types of industries, including newer ones, and forms the basis of many tools in technical analysis such as the Elliott Wave and accumulation and distribution (A/D).

There are six main principles that make up the Dow Theory. They are:

1. The market discounts everything.

2. There are three kinds of market trends.

3. Primary trends occur in three phases.

4. Indices must confirm each other.

5. Volume should confirm price.

6. Trends persist until there is a clear reversal.

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What Are the Six Tenets of Dow Theory?

Here’s more about each of the six principles and how they apply to both institutional and retail investors.

1. The Market Discounts Everything

Like the efficient markets hypothesis, this theory holds that market prices already reflect all available information, so only future events could affect stock prices. Since stocks are always trading at fair market value and are not under or overvalued, investors should make decisions based on market trends.

For instance, if investors believe a particular company will report positive earnings, the market will already reflect this before the announcement, with demand for shares going up before the release of the report.

Those who rely on technical analysis tend to believe in this theory, but investors who use fundamental analysis don’t agree that market value reflects a stock’s intrinsic value.

2. There Are Three Kinds of Market Trends

The second principle of Dow Theory is that there are three kinds of market trends, delineated by their duration.

Primary Trends

These last at least one year and are major market trends including bull trends, bear trends, or sideways trends. They are the most important trends for long term traders to look at, but the secondary and tertiary trends can help identify a specific opportunity such as a reversal in the market.

Secondary trends

These trends only last a few weeks or months. They generally include trends where the price moves in the opposite direction of the primary market trend.

Minor trends or Tertiary trends

Used primarily by day traders, these trends last less than three weeks.

3. Primary Trends are Split into Three Phases

The phases of trends depend on what happened to the price prior to the trend as well as market sentiment. The phase names are ordered differently in a bull and bear market. In a bull market, the phases are: accumulation, public participation, excess and distribution. In a bear market the order reverses.

Accumulation

Assets are low, so smart investors start to buy at this time before the market goes back up.

Public Participation

After the accumulation period and as the market starts to go up, a broader number of investors start to see the trend and begin buying assets, so prices increase significantly and quickly.

Excess and Distribution

In this phase, the general public buys, but informed investors see that the market is at a high and begin selling or shorting the market before it starts to decrease.

4. Indices Must Confirm Each Other

This principle claims that primary trends observed in one market index need to be the same as trends observed in another market index. Originally, the two important indices were the transportation index and the industrial average, but this has changed with the economy over the years. The same principle now applies to other indices. Although industry and transportation are still linked, today, many goods are digital so there can be an increase in the sale of goods without the same increase in transportation.

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5. Volume Should Confirm the Price

This principle states that a strong market trend should correspond with a high trading volume. If there isn’t a large volume in trading, then a trend is not as strong of an indicator of market direction. A low volume trend may not be an indicator of a larger market move.

6. Trends Persist Until there is a Clear Reversal

Another principle is that a market trend will continue until there is a strong indicator of a reversal. Essentially, the market will continue to rise or fall until a primary trend reversal occurs, so investors should not consider secondary and tertiary trend reversals as larger market trends.

Of course, it can be difficult to spot the difference between a primary and secondary trend, so sometimes a secondary trend may actually show a reversal in the market, and a primary trend may turn out to be a misleading secondary trend.

The Takeaway

The Dow Theory consists of six principles that may be used to help explain how the stock market behaves. Although the Dow Theory is over 100 years old, it is still popular and still widely used today for a reason.

Investors often use the Dow as they’re putting together an investment strategy. The Dow and other trading theories may be helpful as you build an online investment portfolio.

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Oct

2023

How to Read a Financial Statements: The Basics

How to Read Financial Statements: The Basics

By Austin Kilham | Growing Wealth, invest, Investing | Comments Off

A company’s financial statements are like a report card that tells investors how much money a company has made, what it spends on, and how much money it currently has.

Knowing how to read a financial statement and understand the key performance indicators it includes is essential for evaluating a company. Any investor conducting fundamental analysis will pull much of the information they need from past and present financial statements when valuing a stock and deciding whether to buy it.

Each publicly traded company in the United States must produce a set of financial statements every quarter. These include a balance sheet, income statement, and cash flow statement. In addition, companies produce an annual report. These statements tell a fairly complete story about a company’s financial health.

Understanding Each Section of a Financial Statement

Along with a company’s earnings call, reading financial statements can give investors clues about whether or not it’s a good idea to invest in a given company.

Here’s what the different sections of a financial statement consist of.

Balance Sheet

A company’s balance sheet is a ledger that shows its assets, liabilities, and shareholder equity at a given point in time. Assets are anything the company owns with quantifiable value. This includes tangible items, such as real estate, equipment, and inventory, as well as intangible items like patents and trademarks. The cash and investments a company holds are also considered assets.

On the other side of the balance sheet are liabilities — the debts a company owes — including rent, taxes, outstanding payroll expenses and money owed to vendors. When liabilities are subtracted from assets, the result is shareholder value, or owner equity. This figure is also known as book value and represents the amount of money that would be left over if a company shut down, sold all its assets, and paid off its debt. This money belongs to shareholders, whether public or private.

Income Statement

The income statement, also known as the profit and loss (P&L) statement, shows a detailed breakdown of a company’s financial performance over a given period. It’s a summary of how much a company earned, spent, and lost during that time. The top of the statement shows revenue, or how much money a company has made selling goods or providing services.

The income statement subtracts the costs associated with running the business from revenue. These include expenses, costs of goods sold, and asset depreciation. A company’s revenues less its costs are its bottom-line earnings.

The income statement also provides information about net income, earnings per share, and earnings before interest, taxes, depreciation, and amortization (EBITDA).

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Cash Flow Statement

A cash flow statement is a detailed view of what has happened with regards to a business’ cash over the accounting period. Cash flow refers to the money that’s flowing in and out of a company, and it is not the same as profit. A company’s profit is the money left over after expenses have been subtracted from revenue. The cash flow statement is broken down into three sections:

• Cash flow from operating activities is cash generated by the regular sale of a company’s goods and services.

• Cash flow from investment activity usually comes from buying or selling assets using cash, not debt.

• Cash flow from financing activity details cash flow that comes from debt and equity financing.

At established companies, investors typically look for cash flow from operating activities to be greater than net income. This positive cash flow may indicate that a company is financially stable and has the ability to grow.

Annual Report and 10-K

Public companies must publish an annual report to shareholders detailing their operations and financial conditions. Look for an annual report to include the following:

• A letter from the company’s CEO that gives investors insight into the company’s mission, goals, and achievements. There may be other letters from key company officials, such as the CFO.

• Audited financial statements that describe financial performance. This is where you might find a balance sheet, income statement and cash flow statement. A summary of financial data may provide notes or discussion of financial statements.

• The auditor’s report lets investors know whether the company complied with generally accepted accounting principles as they prepared their financial statements.

• Management’s discussion and analysis (MD&A).

In addition, the Securities and Exchange Commission (SEC) requires companies to produce a 10-K report that offers even greater detail and insight into a company’s current status and where it hopes to go. The annual report and 10-K are not the same thing. They share similar data, but 10-Ks tend to be longer and denser. The 10-K must include complete descriptions of financial activities. It must outline corporate agreements, an evaluation of risks and opportunities, current operations, executive compensation and market activity. They must be filed with the SEC 60 to 90 days after the company’s fiscal year ends.

MD&A

The management’s discussion and analysis provides context for the financial statements. It’s a chance for company management to provide information they feel investors should have to understand the company’s financial statements, condition, and how that condition has changed or might change in the future. The MD&A also discloses trends, events and risks that might have an impact on the financial information the company reports.

Footnotes

It can be really tempting to skip footnotes as you read financial statements, but they can reveal important clues about a company’s financial health. Footnotes can help explain how a company’s accountants arrived at certain figures and help explain anything that looks irregular or inconsistent with previous statements.

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Financial Statement Ratios and Calculations

Financial statements can be the source of important ratios investors use for fundamental analysis. Here’s a look at some common examples:

Debt-to-Equity

To calculate debt-to-equity, divide total liabilities by shareholder equity. It shows investors whether the debt a company uses to fund its operation is tilted toward debt or equity financing. For example, a debt-to-equity ratio of 2:1 suggests that the company takes on twice as much debt as shareholders invest in the company.

Price-to-earnings (P/E)

Calculate price-to-earnings by dividing a company’s stock price by its earnings per share. This ratio gives investors a sense of the value of a company. Higher P/E suggests that investors expect continued growth in earnings, but a P/E that’s too high could indicate that a stock is overvalued compared to its earnings.

Return on equity (ROE)

Calculated by dividing net income by shareholder’s equity, return on equity (ROE) shows investors how efficiently a company uses its equity to turn a profit.

Earnings per share

Calculate earnings per share by dividing net earnings by total outstanding shares to understand the amount of income earned for each outstanding share.

Current Ratio

This metric measures a company’s abilities to pay off its short-term liabilities with its current assets. Find it by dividing current assets by current liabilities.

Asset turnover

Used to measure how well a company is using its assets to generate revenue, you can calculate asset turnover by dividing net sales by average total assets.

The Takeaway

The financial statements that a company provides are all related to one another. For instance, the income statement reflects information from the balance sheet, while cash flow statements will tell you more about the cash on the balance sheet.

Understanding financial statements can give you clues that could help you determine whether a stock is a good value and whether it makes sense to buy or sell.

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Oct

2023

What Is Market Breadth?

By Laurel Tincher | Growing Wealth, invest, Investing | Comments Off

Market breadth indicators are mathematical formulas that show how many stocks in a particular market or stock index are increasing in price compared to how many are declining in price.

Market breadth is useful for understanding the current and predicted movements of stock indices (groups of stocks and securities based on an industry, region, company size, or other factors), as well as for analyzing stocks and understanding how broad-based a rally or pullback might be.

Determining the breadth of the market requires using a set of technical indicators to assess the price and movement of the index.

What Is Breadth Ratio?

If the majority of stocks in an index are increasing in value, this is called positive market breadth, and the index is said to be in confirmation in this circumstance. This is a bullish indicator that shows that the overall market is in a rising trend and is likely to continue going up in value.

The opposite also holds true. If the majority of stocks are decreasing in value, this is referred to as negative market breadth. This indicates that there is a bearish market sentiment and the index may decrease in value.

If the stock index is rising in value but the market breadth indicators show a negative market breadth, the index is said to be in divergence. And vice versa.

Since market breadth can show the direction of the overall market, traders use it to assess the health of the index as well as the broader market. However, market breadth indicators aren’t always completely accurate, and they can’t be used as predictions of market changes or price reversals.

Sometimes market breadth indicators signal a market movement too early for investors to make use of it. Market breadth is one of the inputs used to generate CNN’s Fear and Greed Index.

How is Market Breadth Used by Investors?

One way institutional and retail investors use market breadth is to reveal underlying market conditions that may not be immediately apparent from looking at the current price movement of an index on a chart. If a few shares in an index have large price movements up or down, this can affect the average and shift the entire index, even if the majority of stocks in the index are going in the opposite direction. The direction of an index is not always an accurate representation of the performance of individual securities that are in the index.

Market breadth can act as a warning to traders to show them potential future price movements of an index, or can show how many stocks are actually moving following a specific market event or trend. Given its limitations, most traders use market breadth in conjunction with other tools and indicators that provide a comprehensive picture of market conditions and the health of the index.

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Types of Market Breadth Indicators

Market breadth indicators are mathematical formulas used to measure how many stocks are rising and falling within an index, as well as their trading volume. Investors use them to discover market sentiment, predict whether an index is likely to rise or fall in the future, and to assess the strength of an upward or downward price trend.

Traders use these indicators along with other types of technical analysis tools such as looking at chart patterns. The difference between breadth indicators and other technical indicators is that technical indicators more broadly signal support and resistance, look for profitable trade signals, and assess trading volume and asset prices. Breadth indicators look specifically at the movements and volume of a stock index.

There are several market breadth indicators used to assess an index. Each indicator shows different information. Together they can confirm stock index price trends, show a picture of index health, and help predict future stock price movements such as reversals. Some market breadth indicators add or subtract each new day’s value from the previous day, making them cumulative calculations, whereas others use each period of time as a separate data point.

Some assess an entire index while others assess individual stocks within an index. Different breadth indicators may be used for different purposes depending on what a trader wants to find out and how in depth they want to go into technical analysis of stocks and indices.

Popular indicators include:

Volume of Trade

One technical indicator often used with market breadth is volume of trade. Volume of trade is the number of shares of a particular stock within an index traded within a particular period of time. Generally, traders look at a period of 52 weeks, or one year. It’s important to look at trading volume of individual stocks because if a stock has a high volume of trade then the price movements have a large impact on the overall index.

Advance/Decline Line

Another popular breadth indicator is the Advance/Decline Line, which adds or subtracts net advances of a new period from those of a previous period. Net advances are the number of increasing or decreasing stocks. This gives a cumulative picture of the direction of the index, showing the investor sentiment for all stocks included in the index.

On Balance Volume (OBV)

To find this indicator, traders add or subtract trading volume based on an index closing price.

McClellan Summation Index

This market breadth indicator creates a running total based on the McClellan Oscillator, with the index going up when the oscillator is positive and down when it is negative.

Arms Index (TRIN)

Investors calculate this indicator by dividing the ratio between increasing and declining stocks by the ratio of increasing to decreasing trade volume.

Chaikin Oscillator

The oscillator shifts with volume and price movements.

Up/Down Volume Ratio

To find this ratio, traders divide rising stock volume by decreasing stock volume.

Up/Down Volume Spread

Traders calculate this indicator by subtracting down volume from up volume.

Tick Index

This indicator looks at how many stocks are trading on an uptick versus how many are trading on a downtick.

New Highs-Lows Index

This indicator looks at a one-year period and compares the number of stocks with a 52-week high to the number with a 52-week low. If more than 50% of stocks have a high or a low, this can be an indication that the index is moving in a bullish or bearish direction.

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Limitations and Downsides of Market Breadth

Although market breadth indicators are a valuable tool for traders, they do have some limitations. They can help investors decide what trades to make, but they do not serve as accurate predictions of the future. They don’t always show upcoming reversals or price confirmations, and are just one tool in analyzing a stock.

Every trading situation is different, so the same indicators can’t be equally useful in all situations. Also, some indicators might show a large or small movement that isn’t reflected in the index price. For instance, if the trading volume changes a lot during a trading day but the price doesn’t change very much, a volume indicator will show a large shift that isn’t an accurate representation of movements in the market.

The Takeaway

Market breadth is a useful technical analysis tool for helping traders understand index markets. Although it has some limitations, it can give them a sense of whether recent market movements reflect broad-based trends or whether large movements by a few stocks are skewing the overall numbers.

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Oct

2023

What Are Emerging Markets?

By Ashley Kilroy | Financial Independence, Growing Wealth, invest, Investing, Terminology | Comments Off

Emerging markets or emerging market economies (EMEs) are in the process of achieving the building blocks of developed nations: they’re establishing regulatory bodies, creating infrastructure, fostering political stability, and supporting mature financial markets. But many emerging markets still face challenges that developed market countries have overcome, and that contributes to potential instability.

To further answer the question, “What are emerging markets?”, it helps to understand developed markets.

Developed economies have higher standards of living and per-capita income, strong infrastructure, stable political systems, and mature capital markets. The U.S., Europe, U.K, and Japan are among the biggest developed nations.

Because these economies wield so much power globally, many investors don’t realize that, in truth, emerging markets make up the majority of the global economy.

India, China, and Brazil are a few of the larger countries that fall into the emerging markets category. Some emerging market economies, like these three, are also key global players — and investors may benefit by understanding the opportunities emerging markets present.

What is an Emerging Market?

In essence, an emerging market refers to an economy that can become a developed, advanced economy soon. And because an emerging market may be a rapidly growing one, it may offer investment potential in certain sectors.

Internationally focused investors tend to see these countries as potential sources of growth because their economies can resemble an established yet still-young startup company. The infrastructure and blueprint for success have been laid out, but things need to evolve before the economy can truly take off and ultimately mature. At the same time, owing to the challenges emerging market economies often face, there are also potential risks when investing in emerging markets.

Investors might bear the brunt of political turmoil, local infrastructure hurdles, a volatile home currency and illiquid capital markets (if certain enterprises are state-run or otherwise privately held, for example).

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Emerging Market Examples

What constitutes an emerging market economy is somewhat fluid, and the list can vary depending on the source. Morgan Stanley Capital International (MSCI) classifies 24 countries as emerging; Dow Jones also classifies 24 as emerging. There is some overlap between lists, and some countries may be added or removed as their status changes. Greece, for example, is no longer considered a developed market but an emerging one.

India is one of the world’s biggest emerging economies. Increasingly, though, some investors see India as pushing the bounds of its emerging market status.

China

China is the second-largest economy globally by gross domestic product (GDP). It has a large manufacturing base, plenty of technological innovation, and the largest population of any country in the world.

Yet China still has a few characteristics typical of an emerging market. For example, the gross national income per capita falls below the threshold established by the World Bank for a developed country: about $12,600 per year versus the higher standard of above $13,200 per year. With its Communist-led political system, China has embraced many aspects of capitalism in its economy but investors may experience some turbulence related to government laws and policy changes. The Renminbi, China’s official currency, has a history of volatility. And finally, post-Covid, China’s economy has lagged.

India

India is another big global economy, and it’s considered among the top 10 richest countries in the world, yet India still has a low per-capita income that is typical of an emerging market and poverty is widespread.

At the same time, India was ranked as being among the more advanced emerging markets, thanks to its robust financial system, growing foreign investment, and strong industrials, especially in telecommunication and technology.

Characteristics of an Emerging Market Economy

As noted above, there isn’t a single definition of an emerging market, but there are some markers that distinguish these economies from developed nations.

Fast-Paced Growth

An emerging market economy is often in a state of rapid expansion. There is perhaps no better time to be invested in the growth of a country than when it enters this phase.

At this point, an emerging market has laid much of the groundwork necessary for becoming a developed nation. Capital markets and regulatory bodies have been established, personal incomes are rising, innovation is flourishing, and GDP is climbing.

Lower Per-Capita Income

The World Bank keeps a record of the gross national income (GNI) of many countries. For the fiscal year of 2022, lower-middle-income economies are defined as having GNI per capita of between $1,136 and $4,465 per year. At the same time, upper-middle-income economies are defined as having GNI per capita between $4,466 and $13,845. (By way of contrast, the U.S. is considered a high-income economy, with a GNI of $76,370.)

The vast majority of countries that are considered emerging markets fall into the lower-middle and upper-middle-income ranges. For example, India, Pakistan, and the Philippines are lower-middle-income, while China, Brazil, and Mexico are upper-middle-income. Thus, all these countries are referred to as emerging markets despite the considerable differences in their economic progression.

Political and Economic Instability

For most EMEs, volatility is par for the course. Risk and volatility tend to go hand in hand, and both are common among emerging market investments.

Emerging economies can be rife with internal conflicts, political turmoil, and economic upheaval. Some of these countries might see revolutions, political coups, or become targets of sanctions by more powerful developed nations.

Any one of these factors can have an immediate impact on financial markets and the performance of various sectors. Investors need to know the lay of the land when considering which EMEs to invest in.

Infrastructure and Climate

While some EMEs have well-developed infrastructure, many are a mix of sophisticated cities and rural regions that lack technology, services and basic amenities like reliable transportation. This lack of infrastructure can leave emerging markets especially vulnerable to any kind of crisis, whether political or from a natural disaster.

For example, if a country relies on agricultural exports for a significant portion of its trade, a tsunami, hurricane, or earthquake could derail related commerce.

On the other hand, climate challenges may also present investment opportunities that are worth considering.

Currency Crises

The value of a country’s currency is an important factor to keep in mind when investing in emerging markets.

Sometimes it can look like stock prices are soaring, but that might not be the case if the currency is declining.

If a stock goes up by 50% in a month, but the national currency declines by 90% during the same period, investors could see a net loss, although they might not recognize it as such until converting gains to their own native currency.

Heavy Reliance on Exports

Emerging market economies tend to rely heavily on exports. That means their economies depend in large part on selling goods and services to other countries.

A developed nation might house all the needs of production within its own shores while also being home to a population with the income necessary to purchase those goods and services. Developing countries, however, must export the bulk of what they create.

Emerging Economies’ Impact on Local Politics vs. Global Economy

Emerging economies play a significant role in the growth of the global economy, accounting for about 50% of the world’s economic growth. Moreover, it’s predicted that by 2050 three countries will have the biggest economies: the U.S., China, and India, with only one currently being a developed economy.

But, while emerging markets help fuel global growth, some of those with higher growth opportunities also come with turbulent political situations.

As an investor, the political climate of emerging market investments can pose serious risks. Although there is potential for higher returns, especially in EMEs that are in a growth phase, investors need to consider the potential downside. For example, Thailand and South Korea are emerging economies with high growth potential, but there is also a lot of political unrest in these regions.

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Pros and Cons of Investing in Emerging Markets

Let’s recap some of the pros and cons associated with EME investments.

Pros

• High-profit potential: Selecting the right investments in EMEs at the right time may result in returns that might be greater than most other investments. Rapidly growing economies could provide ample opportunity for profits. But as noted above, it’s impossible to guarantee the timing of any investment.

• Global diversification: Investing in EMEs provides a chance to hold assets that go beyond the borders of an investor’s home country. So even if an unforeseen event should happen that contributes to slower domestic growth, it’s possible that investments elsewhere could perform well and provide some balance.

Cons

• High volatility: As a general rule, investments with higher liquidity and market capitalization tend to be less volatile because it takes significant capital inflows or outflows to move their prices.

EMEs tend to have smaller capital markets combined with ongoing challenges, making them vulnerable to volatility.

• High risk: With high volatility and uncertainty comes higher risk. What’s more, that risk can’t always be quantified. A situation might be even more unpredictable than it seems if factors coincide (e.g. a drought plus political instability).

All investments carry risk, but EMEs bring with them a host of fresh variables that can twist and turn in unexpected ways.

• Low accessibility: While liquid capital markets are a characteristic of emerging markets, that liquidity still doesn’t match up to that of developed economies.

It may be necessary to consult with an investment advisor or pursue other means of deploying capital that may be undesirable to some investors.

Why Invest in Emerging Markets?

Emerging markets are generally thought of as high-risk, high-reward investments.

They are also yet another way to diversify an investment portfolio. Having all of your portfolio invested in the assets of a single country puts you at the mercy of that country’s circumstances. If something goes wrong, like social unrest, a currency crisis, or widespread natural disasters, that might impact your investments.

Being invested in multiple countries can help mitigate the risk of something unexpected happening to any single economy.

The returns from emerging markets might also exceed those found elsewhere. If investors can capitalize on the high rate of growth in an emerging market at the right time and avoid any of the potential mishaps, they could stand to profit. Of course timing any market, let alone a more complex and potentially volatile emerging market, may not be a winning strategy.

Recommended: Pros & Cons of Global Investments

The Takeaway

While developed nations like the U.S. and Europe and Japan regularly make headlines as global powerhouses, emerging market countries actually make up the majority of the world’s economy — and possibly, some very exciting opportunities for investors.

China and India are two of the biggest emerging markets, and not because of their vast populations. They both have maturing financial markets and strong industrial sectors and a great deal of foreign investment. And like other emerging markets, these countries have seen rapid growth in certain sectors (e.g. technology).

Despite their economic stature, though, both countries still face challenges common to many emerging economies, including political turbulence, currency fluctuations and low per-capita income.

It’s factors like these that can contribute to the risks of investing in emerging markets. And yet, emerging markets may also present unique investment opportunities owing to the fact that they are growing rapidly.

Emerging market exchange-traded funds (ETFs) might invest in different assets within a single country or spread their investments throughout multiple countries. Bonds can also play a role in an emerging market portfolio. Many countries with developing economies have used the issuance of new debt to borrow money to build out their infrastructure. That means some emerging economies could offer bonds with attractive yields. But investors need to carefully weigh the potential risks.

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Oct

2023

Introduction to Weighted Average Cost of Capital (WACC)

By Brian O'Connell | Financial Independence, Growing Wealth, invest, Investing, Terminology | Comments Off

Properly formulated, the weighted average cost of capital, or WACC, merges a business’s cost of capital across financial components. Once weighted for proportional balance, WACC bundles all company financial sources (with an emphasis on equity and debt) and adds them together. The final figures represent the current value of a company, or a project or initiative undertaken by a company.

Understanding the weighted average cost of capital, or the cost of capital, is both a business calculus and an economic term. It’s a term to describe the relationship between two key economic components – equity and debt, as a financial ratio.

What Is WACC?

The WACC is the rate that a company must pay, on average, to finance its operations. It’s a figure that business leaders use to make strategic decisions, and a data point used by investors as part of their fundamental analysis of a company.

In general, a low weighted average cost of capital shows that a business is in good financial health and can more efficiently and economically pay for company operations, either through debt financing or equity financing. Earnings are robust enough to curb company debt loads and offer solid investment returns to market investors, which should increase capital to the company.

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A higher weighted average cost of capital suggests the opposite outcome. The firm is likely paying more to handle their debt and paying more to raise capital for company projects. That scenario can lead to a business with a lower valuation with less demand from investors to buy company stock or invest in its bond issues, as returns on those investments would likely be lower.

Who Uses Weighted Average Cost of Capital?

The weighted average cost of capital formula can be used by a number of people in or around a business. That can include company management, who can use it to guide decisions about the direction of the company, along with investors and investment analysts, who are keeping tabs from the outside.

High vs Low WACC Calculations

Investors can use the results of WACC calculations to help guide their investment decisions. In general, a high WACC may be a turn-off for some investors, as it indicates that the company isn’t as likely to provide investors with a high rate of return. The opposite is also true – a low WACC may be a bullish sign for investors.

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What is the WACC Formula?

The calculation used for WACC includes cost of equity and cost of debt, along with additional economic components commonly used by businesses.

Here is how those components are broken down in a WACC formula.

• E = Market value of the business’s equity

• V = Total value of capital (equity + debt)

• Re = Cost of equity

• D = Market value of the business’s debt

• Rd = Cost of debt

• T = Tax rate

Once you have those numbers, here’s how to calculate WACC:

How to Calculate WACC

Calculating WACC looks like this:

WACC = (E/V x Re) + ((D/V x Rd) x (1-T))

To use the WACC formula, you need to first multiply the costs of each financial component and include that component’s proportional rate. Once you’ve arrived at those figures, multiply them by the company’s corporate tax rate. The resulting figure gives you the company’s weighted average cost of capital.

Difficulties With Using WACC

There’s a caveat to be mindful of when calculating the weighted average cost of capital: The formula heavily relies on the cost of equity in its equation, which is largely unknown, since that value can vary. A company’s share capital depends on what the market (i.e., investors) are willing to pay to invest in the company, as exhibited by the company’s stock price.

Given that unknown, companies must evaluate the expected return of their stock, through an investor’s eyes. That represents the value of the company’s equity and any effort to hide or diminish that value could put a damper on a company’s share price.

That’s why companies factor the estimated cost of equity into the WACC equation – they view the cost of equity as the amount of capital a company needs to spend to maintain a stock price that’s largely acceptable to market investors.

An Example of the WACC at Work

As an example of the WACC at work, let’s look at a company’s weighted average cost of capital – let’s say ABC Company has an annual return of 15% and an average cost of 5% annually to pay for operations. That dynamic represents a 10% profit on its investment in the company.

From an investor’s viewpoint, that same profit scenario represents 10 cents of every dollar invested in the company. That’s 10 cents of capital a business can use to either invest back into the company or can be used to pay down company debt.

On the other end of the equation, if XYZ Company generates an annual investment return of 10% yet owns an average annual cost of capital of 15%, that company is down 5 cents on each dollar invested in the company.

In that scenario, XYZ Co. is in a bind that no company wants to find itself in – its costs of doing business exceed its investment returns. That translates into fewer investors until the firm realigns its financing picture, cuts debt, and gives investors a good reason to buy its stocks and bonds.

Why the Need for Weighted Average Cost of Capital?

The weighted average cost of capital breaks down a firm’s cost of doing business by weighing the debt (including bonds and other long-term debt) and equity structure (including the cost of both common and preferred stock) of the company.

Primarily, companies need to finance their operations in three ways:

1. Debt financing

2. Equity financing

3. A combination of debt and equity

No matter which option a company chooses, sources of capital come with a financial cost.

The WACC seeks to find the “true cost of money” in operating a business by comparing the cost of borrowing of capital to run a company versus raising capital through equity to pay for common business needs like property and equipment, research and development, human capital (i.e., employees), and business expansion, among other costs.

When company executives know the WACC, they can leverage that financial ratio to decide on funding the firm through debt or equity financing. The cost of equity will depend on the value of the company’s stock, while the cost of debt will reflect interest rates.

Basically, companies require an accurate weighted cost of capital to properly weigh expenses and provide fair cost of analysis on projects in the pipeline. Additionally, companies can leverage their WACC to evaluate their capital structure and weigh the myriad financial sources needed to fund operations, proportioned accurately.

Using one form of capital to fund a company’s operations makes the cost of capital formula fairly simple. However, when companies use multiple forms of capital the formula becomes more complicated and requires financial modeling.

The Takeaway

The weighted average cost of capital is not exactly a precise measurement of a company’s financial health, but it can be a highly useful one, especially for investors. If you’re looking at potentially investing in a company, it can be one piece of information that provides more detail into the company’s relative strength.

The data is easily found in a publicly-traded company’s balance sheets, which are made available to investors on a regular basis. Just visit the company’s web site, locate its financial information page, and look for the relevant data.

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FAQ

How can you calculate WACC for a private company?

Calculating WACC for a private company is more or less the same process as calculating WACC for a public company, but the calculation will need to be done using estimates of the company’s value, perhaps through cash flow analysis.

What is the difference between WACC and Required Rate of Return (RRR)?

While WACC and RRR are similar, the two are distinct from one another. In fact, WACC can be a tool used to determine RRR, but the two produce different values that can be important for investors for different reasons.

How does WACC influence sensitivity analysis?

WACC calculations can change in different scenarios, and sensitivity analysis can help determine how and what those changes are. Effectively, by experimenting with different values, you can get a sense of how sensitive a WACC calculation is, which can be important for investors.

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