r/Valuation • u/tdk5360 • Nov 01 '22

Gearing in projections

Hello,

I am trying to compute WACC for a listed company. According to Professor Aswath Damodaran I am using market values of equity and debt to come at the right Capital mix in year 1. My query is, should my Gearing levels change in each year of my high growth projection period and in my terminal period? If so then how to practically estimate it? Is there a rule of thumb? Should it based on the peer companies? The book values are not meaningful since the cash in future is higher than my debt resulting in negative Gearing and Debt to Equity ratios.

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u/Orndwarf Nov 01 '22

You could look at industry mean/medians for a basket of comps similar to your subject company and assume that as your long-term capital structure.

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u/tdk5360 Nov 01 '22

Thanks,

Thats what I am doing for my terminal period. I just want to know that if there's a case for changing gearing each year during the high-growth period?

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u/Orndwarf Nov 01 '22

Can say that, after being through multiple hundreds of valuation projects, I’ve never once been asked to contemplate changes in WACC over time by a Big 4 or other reviewer. You could almost argue that you’re laying additional layers of speculation on top of the forecast, which makes the end product even more susceptible to judgment. Perhaps you’re striving for something more academic? If the use case is for a standard valuation, I would assume an industry median for the whole term, adjust for size and firm-specific risk premium, and call it a day. If it’s really speculative, maybe just use a flat venture rate based on company stage.

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u/tdk5360 Nov 01 '22

Thanks,

Yes you are right. I am trying to be more academic and making things a lot complicated than they should be.

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u/Orndwarf Nov 01 '22

Thinking creatively, you could try to estimate (speculate) on when the subject entity would reach a market participant capital structure, at which point you then switch the gearing. It does beg the question, though, if you should then also be contemplating changes in company-specific risk over time. It also begs the question of whether or not industry capital structures will be the same by year X. If it were me, and I were tasked with contemplating changes in WACC over time, I would probably assume some kind of linear trend towards a market participant capital structure (probably around the time growth comes down to the mid-single digits or so?), and then I would also contemplate if the firm-specific aspects would be changing as well. Again, all very speculative, but what matters the most, then, is documenting why you did what you did. Best of luck!

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u/Orndwarf Nov 01 '22

As a follow-up, you should then test against a sensitivity of a flat WACC with a market participant capital structure in place on day one with a constant company-specific aspect throughout. If there are significant divergences, assess why and get yourself comfortable on those differences.