P/E ratios are impacted by a company's choice of capital structure - companies which raise money via debt will have lower P/Es (and therefore look cheaper) than companies that raise an equivalent amount of money by issuing shares, even though the two companies might have equivalent enterprise values (For example, if a company with debt were to raise money by issuing shares of stock, and then used the money to pay off the debt, this company's P/E ratio would shoot up because of the increased number of shares - although nothing about the fundamental value of the business has changed).

1) Why will companies that raise money via debt have a lower p/e? What's the math here? Where does debt fit into the p/e equation?

2. "For example, if a company with debt were to raise money by issuing shares of stock, and then used the money to pay off the debt, this company's P/E ratio would shoot up because of the increased number of shares ". why is this? Where does money raised by issuing shares fit into the p/e equation?

Do you mean P/E or EV/EBITDA? two different metrics..

P/E is more or less based on the market's perception of company future earnings. EV/EBITDA has more to do with the company's capital structure.

Capital structure has no real effect on Price / Earnings other than as a result of investor belief and share price. Debt has no direct effect on P/E. P/E is a very simple calculation which is just share price divided by EPS. Debt could have an indirect effect on P/E in the following scenarios:

- In the future, interest payments on debt might reduce EPS
- Debt issuance can give a signal to investors which will cause the price to change

EV is very different as it does actually take debt into account. The issuance of debt (all other things being equal) would reduce the EV of a company and if EBITDA was unchanged, this would lead to a lower EV / EBITDA multiple.

On #1, if you raise money via debt you have fewer shares outstanding, so EPS is higher, thus P/E is lower.

I think the answer to #2 is that, upon issuing new shares, EPS goes down as there are more shares but obviously the same amount of earnings. EPS is the denominator of the P/E ratio, so if the denominator decreases, the ratio increases. This is assuming price does not change.

Asatar:
EV is very different as it does actually take debt into account. The issuance of debt (all other things being equal) would reduce the EV of a company and if EBITDA was unchanged, this would lead to a lower EV / EBITDA multiple.

EV is net debt plus equity. Issuing debt would raise the EV, and lead to a higher EV / EBITDA multiple.

Consultant to a Fortune 50 Company

It has to do with the expected return on debt versus equity and the impact that has on valuation multiples.

1. In lay man's terms, they have a lower PE because they are now more levered and the equity is riskier. Just model it out and you'll get an idea of the math. The debt has to be paid back and is senior to the equity.
2. The company has a theoretical "return on total assets". In a levered company, the "return on debt" is less than the "return on total assets" which is in turn less than the "return on equity" (look up WACC). By selling equity to retire debt, you are reducing the risk level to the equity component by removing the debt component. Because the return on assets stays constant, the expected rate of return on the debt goes down, and thus the P/E multiple rises.

Honestly, all this financial engineering is just such total bullshit. Everyone's trying to pick up nickels by trying to figure out whether they should do 10% debt or 30% debt instead of figuring out how to run a fucking company. Apple has zero debt. I'm sure it bugs some financial "wizards" that they do. Talk about missing the forest for the trees. (Yes, I know Modigliani Miller is not reality; but finance guys making 8 figures because somehow they are creating that value by changing the cap structure of a company is lunacy; it's just more fooled by randomness crap).

Consultant to a Fortune 50 Company

HezBalla:
P/E ratios are impacted by a company's choice of capital structure - companies which raise money via debt will have lower P/Es (and therefore look cheaper) than companies that raise an equivalent amount of money by issuing shares, even though the two companies might have equivalent enterprise values (For example, if a company with debt were to raise money by issuing shares of stock, and then used the money to pay off the debt, this company's P/E ratio would shoot up because of the increased number of shares - although nothing about the fundamental value of the business has changed).

1) Why will companies that raise money via debt have a lower p/e? What's the math here? Where does debt fit into the p/e equation?

2. "For example, if a company with debt were to raise money by issuing shares of stock, and then used the money to pay off the debt, this company's P/E ratio would shoot up because of the increased number of shares ". why is this? Where does money raised by issuing shares fit into the p/e equation?

Where are you getting this from? Companies with debt do not necessarily have lower P/E ratios.

The Modigliani/Miller perspective is that the firm value is unaffected by the capital structure. EV = Debt + Equity. If you increase debt, there is a dollar for dollar decrease in equity.

This isn't quite complete however because the cost of debt and equity are affected by the amount of leverage, because it changes the riskiness of the firm. Financing entirely with debt would result in a prohibitively high interest rate. Financing entirely with expensive equity is also inefficient. If you have an idea of the market rates for debt and equity at various levels of leverage, you can calculate a debt/equity combination that minimizes the weighted average cost of capital and therefore maximizes the value of the firm. So depending on where you are relative to the optimal capital structure, you can increase or decrease firm value by issuing debt or equity.

I am wise because I know that I know nothing -Socrates

So many dumb replies in this thread. Mother of god. I'll drop a preftigious response soon, brothers.

alexpasch:
Asatar:
EV is very different as it does actually take debt into account. The issuance of debt (all other things being equal) would reduce the EV of a company and if EBITDA was unchanged, this would lead to a lower EV / EBITDA multiple.

EV is net debt plus equity. Issuing debt would raise the EV, and lead to a higher EV / EBITDA multiple.

yea totally, just before PE firms sell their companies they load them up with debt to get massive exits, because equity never changes, right? and the "net" in net debt is just for decoration...

"After you work on Wall Street it's a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side." - David Tepper

Holy shit.. Never seen so many bad replies. Issuing debt doesnt affect P/E? Lol what about interest expense

EV unaffected by debt; 500mm of debt nets out with 500mm of cash proceeds.

Wtf is going on here

mrb87:
EV unaffected by debt; 500mm of debt nets out with 500mm of cash proceeds.

Wtf is going on here

Obviously when you issue debt you get cash, but who the hell just sits on the cash of a debt issuance? For example if you invest it in PPE the ttm EBITDA obviously won't reflect that. Enterprise value will be higher, but EBITDA won't.

Consultant to a Fortune 50 Company

Oreos:
alexpasch:
Asatar:
EV is very different as it does actually take debt into account. The issuance of debt (all other things being equal) would reduce the EV of a company and if EBITDA was unchanged, this would lead to a lower EV / EBITDA multiple.

EV is net debt plus equity. Issuing debt would raise the EV, and lead to a higher EV / EBITDA multiple.

yea totally, just before PE firms sell their companies they load them up with debt to get massive exits, because equity never changes, right? and the "net" in net debt is just for decoration...

See my prior post. I am assuming the debt gets invested and you're not just grossing up the balance sheet. The EV would be higher, because you have more assets due to whatever you buy with the debt. Whether this would be good or bad for equity value depends on the perceived value of the asset bought with the debt relative to the value of the debt. If we're talking immediately after the investment, equity value will be unchanged.

Let's say you have a house you rent out worth \$100K. You borrow \$50K to build an addition. Once the addition is built, your prior rents collected wont show the new rent potential of the addition (EV/EBITDA multiple is higher). Your house is now worth \$150K (enterprise value is higher). Equity value in theory remains unchanged (though depending on whether the addition was a good investment, equity value may change).

Where in my earlier post did I say that grossing up the balance sheet was always (or even ever) a good idea, let alone that private equity firms do this to get massive exits? I said the multiple goes up (referring to ttm multiple), I did not say wealth is created out of thin air...

Consultant to a Fortune 50 Company

alexpasch:
mrb87:
EV unaffected by debt; 500mm of debt nets out with 500mm of cash proceeds.

Wtf is going on here

Obviously when you issue debt you get cash, but who the hell just sits on the cash of a debt issuance? For example if you invest it in PPE the ttm EBITDA obviously won't reflect that. Enterprise value will be higher, but EBITDA won't.

So the assets purchased don't earn any income? Your EBITDA in this case will be adjusted pro-forma for the earning power of those assets you purchased. Is the company buying gold and locking it up in a vault?