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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?

Comments (14)

  • Asatar's picture

    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.

  • Boothorbust's picture

    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.

  • In reply to Asatar
    alexpasch's picture

    Asatar wrote:
    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

  • alexpasch's picture

    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

  • ThunderRoad's picture

    HezBalla wrote:
    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

  • In reply to alexpasch
    Oreos's picture

    alexpasch wrote:
    Asatar wrote:
    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...

    .

  • In reply to mrb87
    alexpasch's picture

    mrb87 wrote:
    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