Companies with lower cost of equity than cost of debt?
So, let’s say a company has a P/E of, say, 25x
So the inverse … its “earnings yield” … would be 4%, which is pretty low, lower than treasury yields right now.
I would assume that a company’s cost of debt would be higher than that of treasuries (how could this not be?), as these companies will come with higher risk.
But it sounds a little simplistic to say “if the company has a P/E above ~25x, equity is cheaper to raise than debt”
So, for what kinds of companies would equity be cheaper to raise than debt, and how do we really figure this out? How is that evolving right now as treasury yields fall and company valuations also fall? Does that tilt things to a more “cheaper to raise debt than equity” kind of world?
Cost of equity and earnings yield are different concepts
Shouldn’t they be related though?
If cost of equity is risk free rate + beta*(expected return - risk free rate)
And earnings yield is below risk free rate
Shouldn’t expected return also be quite low … if not negative?
This paper helps explain
https://www.tandfonline.com/doi/pdf/10.1080/10293523.1993.11082327
Thoughtful question. To clear up something (not that you're saying this, but for anyone reading), the cost of equity as you're describing it is different to the cost of equity in the WACC formula (although the two things are related).
It is simple as you say, but issuing new equity can be a cheaper form of financing than raising debt, and that's why you often see high value stocks "use" their stock price to effect acquisitions (or raise new capital for other purposes - think how Tesla did several stock issuances when its stock rode high). Figuring out which companies this applies to is just a matter of observing the share price to earnings ratio - the highest ratios are seen in high growth companies, typically.
Suppose you're a CEO, and (taking to its extreme), your P/E ratio is infinite (0 net income). You want to make an acquisition - what reason would there be to raise debt?
Yes, this all makes sense, thank you.
My understanding is this:
COE: Risk free rate + beta(expected return - risk free rate)
Earnings Yield: (P/E)^-1
However … if earnings yield is low…say…lower than treasury yields, shouldn’t “expected return” in the COE formula also be low?
I cannot imagine a scenario in which earnings yield is moving up whilst expected return is moving down, mathematically.
Is it the case, though, since earnings yield is an imperfect proxy for COE, an earnings yield has to be *much lower than treasury yields (rather than just a little bit lower) for COE to actually be lower than cost of debt?
Like … maybe for some ultra high growth hot biotechs in a high-valuation market, but not for your run-of-the-mill 25x P/E company, would COE actually be lower than cost of debt?
What you are missing (and again, this is a good question), is that the earnings yield is a point-in-time figure. The (CAPM-derived) cost of equity is an infinite horizon concept. If the earnings yield suddenly became low forever and with certainty, then a your hypothetical high P/E stock should (theoretically at least) drop.
P/E(t+1) = 1 / (WACC - g)
Now, let's say there is no growth and, in fact, the company blows up in period 2 (today, t = 0). Then your earnings yield is E(t+1)/P = 1 / WACC, and assuming no debt, you have the relationship.
Does this help intuitively?
Wouldn't a company's CoE intuitively always be higher than CoD given that equity investors would always need to demand a premium to debt investors due to being lower in the cap structure?
What if expected equity return is lower than expected return on treasuries … why would you spend more on an equity that has a lower expected return than treasuries?
Sure, this could only be an extreme high-valuation case, but theoretically possible
Fair enough, I suppose that saying "always" was inaccurate on my part given that such edge cases can exist.. but I would argue that in most (normal) conditions the logic holds.
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