Capital Structure and P/E Part Two

Leverage and Price vs. Earnings Ratios

Following up on the post immediately prior to this one, I found a slide from a certain consulting firm entitled “Leverage distorts P/E multiples.” It essentially shows two companies with identical enterprise value and EBITDA, but with different capital structures and very different P/E ratios.

A couple of first-level observations on the slide itself:

1) P/E being influenced by leverage is more of a practical observation rather than something that is mathematically true and it is driven by the fact that debt is cheaper than equity.

If this slide had been built up such that debt has the same cost as equity (the same way as my thought experiment), the interest cost would be $25 rather than $20 and the P/E ratio would remain the same in the two scenarios (as in my though experiment). I suppose I could be convinced that debt financing is always cheaper than equity financing due to its seniority.

2) A potential interpretation of this slide is that investors should be indifferent between investing in Company A and Company B and shouldn’t be fooled by the lower P/E ratio of Company A. I disagree.

Company A, with the lower P/E ratio is getting much, much cheaper financing to the tune of $5M per year vs. the all-equity financing. I might much rather own Company A, provided that I am okay with the more junior position (since I’m behind the entire pool of debt). So the low P/E ratio is telling me something here.

Second level ruminations sparked by what I’ve learned here:

1) Coming back to the issue of which company I would prefer to invest in… I guess the subissues would break out into the ROIC that the company would be able to generate on its retained earnings and whether the interest rate is high or low.

If ROIC is running really high, then I want the company to hold onto its earnings and to be invested in Company B. If the interest rate is running low, then I want to have the cheap financing of Company A. I think I compare ROIC vs. interest rate for $ generation and then perhaps ROIC vs. WACC if I then care about alpha.

2) Understanding this also solves in my mind the mystery of how capital structure can make transactions accretive vs dilutive to EPS… debt is cheaper than equity in the banker models.


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