Leverage Effect on PE Multiple
Hi,
Can someone please explain the effect of leverage on the P/E ratio?
In a theoretical situation, increasing the amount of debt increases the interest expense and thus reduces net income. So P/E would rise?
Theoretically, would the share price change at all?
Impact of Increased Debt on P/E Multiple
The answer to the OP's question is in no way straight forward answer as taking on debt can impact both the numerator and the denominator of P/E. First let's review what the P/E ratio is.
What is a P/E Ratio?
The P/E ratio looks at the current price divided by the earnings of the company for a given period of time (which could be the last twelve months of earnings or the next twelve months of earnings). This could be market cap / net income or share price / EPS.
The Leverage Impact on the P/E Ratio
When considering the impact that issuing additional debt will have on the multiple - you should consider the numerator and the denominator separately.
Looking first at the denominator - earnings will be directly impacted as this is net income or EPS from the income statement. Therefore, with additional debt, the company will be paying additional interest which will lower the earnings of the company. A lower denominator will result in a higher P/E multiple.
However, in an ambiguous prompt such as this we don't know what the debt is being used for. If debt is issued to make an investment that could increase earnings - the earnings could actually grow result in in a higher P/E multiple.
As mentioned above, this debt could go to a variety of different projects which will impact the P/E ratio in different ways:
- Make a strategic investment - example: Amazon buys Whole Foods with debt
- Repurchase shares - example: Coco-Cola buys back stock with debt
- Fund current operations in a difficult environment - example: Sears issues to debt to stay in business
- Potentially sit on the balance sheet or pay back existing debt (i.e. refinance)
The first three scenarios would be a boost for investor's sentiment regarding the company which could increase the share price and therefore increase the P/E multiple.
- Making strategic investment - could have a positive impact on sentiment for the company and will also increase the EPS of the business (in most scenarios)
- Share repurchases - if a company repurchased shares that would also lower the share count and therefore increase the EPS and lower the P/E of the company
- Issue debt to fund operations - keep business afloat which creates positive price sentiment
In all of these scenarios the earnings will be lowered by interest expense but may be increased depending on what the debt is being used for. With all this in mind, it is impossible to say whether the P/E multiple will go up or down.
If asked about this in an interview, you should explain that there are a variety of moving pieces but that all else being equal the P/E multiple will rise because of the effect of additional interest expense.
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ehhh, it's not that straightforward. what you're saying is theoretically correct. absent a price change, if E goes down then PE must go up, but PEs are more based on industry and individual company performance (and the opinions of investors on same) than debt load. for sure, debt is a measure of risk and thus may make the multiple come down (higher debt=supposedly higher risk=less willing to pay up for earnings---->lower PE), or it could go the other way as you suggest.
tldr: debt is important when analyzing a company, but I don't see a direct relationship to PE
It also depends on what you do with this additional debt. If you just raise it and let it sit on your balance sheet it will lower earnings which could lower price which would mean the P/E ratio remains constant. Now if the firm uses this additional debt to fund a very attractive investment opportunity investors can expect higher future earnings and thus the P/E ratio would probaly rise.
Best practice to assume debt is taken for a reason.
Agree with brofessor.
While taking on more debt will reduce Earnings via interest expense, it will also increase investors K (required rate) due to the increased risk (which would increase the Price of the stock). You can't predict with certainty the exact result, but yes, if you take an economic 'all else being equal' approach, your theoretical situation could hold true.
To youjustgotlittup, looking at forward PE, it can be broken down to Payout / k-g. So again, investing your debt in profitable investments will increase g, but will still be offset to some extent by an increase in k.
It will decrease your P/E ratio ceteris paribus. Net income in a highly levered business is more risky than net income in an unlevered business and thus deserves a lower multiple.
You just have to think in terms of what your earnings are worth. Earnings are worth more if they have a great growth potential and are less volatile (less risky). Earnings are worth less if they don't grow or even decrease and are highly volatile (risky).
If a company issues debt, how does its P/E ratio change? (Originally Posted: 09/12/2013)
Assume you have two identical companies and one of them (Company A) issues $1m in debt. How does its P/E ratio change relative to Company B?
If it issues debt (and we'll assume that $1 million sits in the bank after issuance earning 0%), earnings will decrease due to the interest payments associated with the debt. If market cap doesn't change, P/E goes up.
However, the company will/should do something with that money that will earn more money than the associated interest payments. If that is the case, earnings go up but so does price, as the market assigns value to the transaction and subsequent investment. How much each goes up depends on a number of factors (including future expectations), so P/E could end up increasing, decreasing or staying the same.
You need much more detail in your question. Its almost like asking. "Hey if I dig in the ground can I find gold?" Well sure you can but do you have any idea what you are doing or looking for?
+1. As it was said before, you have to know what they are doing with the money. Investing it? How? What is their rate of return? What is the rate of interest? Did the share price change because of this? Are they simply lighting the money on fire? There's too many variables here.
As above, you need a fuck-ton of more detail, and frankly there is no way to know how the share price will react to the debt issuance, if at all. Theoretically speaking, new debt = increased interest expense = lower net income = lower earnings. From a market value of equity perspective, assuming no change to TEV, cash increased but debt also increased by the same amount, thus no change to net debt, thus no change to implied equity value. Thus P/E increases. But again, that is suuuper theoretical
Please add more detail and we will be able to help
This is a question I received in an interview - realize it's open ended, but this is exactly how it was phrased. I was looking to confirm my approach and see if I was missing something. I only got far as earnings are concerned but the interviewer gave no further detail.
Thanks, I don't have a background in finance so this took me by surprise.
GCM interview at one of GS/MS/JPM.
@Tar Heel Blue nicely put, I would give an SB if I could.
You can do two things: 1) ask clarifying questions 2) make your own assumptions. e.g. "If I assume that all other variables are constant, price will go down because of the increased interest expenses associated with the debt issuance."
Personally I would go with 2). Your interviewers would sometimes follow-up and you could go into more details.
I got the same question, got smacked :(
Hm, I'd answer it like this (disclaimer...I ask this to people I interview...the key is to ask questions and inquire, and play out different scenarios, as when you are a banker you will be modeling out multiple scenarios on a daily basis):
If you issue $1mm in debt and let the cash sit on the balance sheet without utilizing the capital, your P/E ratio increases (gets more expensive). Net income falls, outstanding equity outstanding stays same. Management isn't doing anything, and this theoretically would upset me as a shareholder - though if you are a company officer, maintaining liquidity and raising capital at low rates makes sense and if you are a big cap company, the change in P/E is minor.
If you issue $1mm in debt to buy back $1mm in outstanding shares, depending on your P/E ratio versus your interest rate, P/E could go up or down. Usually P/E ratio will improve (become lower) relative to competitor. If P/E ratio is lower than ratio of debt to post-tax interest cost, it'll improve...here is an example:
Earning $50mm on a $400mm MCAP, your P/E ratio is 8x... Then you execute a $100mm buyback at a 10% interest rate...leads to $300mm MCAP and earnings of $43.5mm (the $10mm interest charge is pre-tax at say a 35% rate) Now your new P/E ratio is under 7.0x - Voila! Except now you are more leveraged. Welcome to the world of activist investing...take a look at activist investor's general buyback strategies.
So the answer: it depends The best answer: it depends...if you do this, then this happens, etc.
For the following "If you issue debt and are putting it into maintenance capex that'll likely increase your P/E ratio, " Did you mean to say that it would 'decrease' your P/E ratio?
If the firm requires financing to maintain capex every period than thats a bad sign about the firm that should lower the price. Assuming the decrease in the numerator would be larger than the decrease in Earnings(bec. of interest) , the P/E ratio should go down
For the following "If you issue debt and are putting it into maintenance capex that'll likely increase your P/E ratio, " Did you mean to say that it would 'decrease' your P/E ratio?
If the firm requires financing to maintain capex every period than thats a bad sign about the firm that should lower the price. Assuming the decrease in the numerator would be larger than the decrease in Earnings(bec. of interest) , the P/E ratio should go down
For the following "If you issue debt and are putting it into maintenance capex that'll likely increase your P/E ratio, " Did you mean to say that it would 'decrease' your P/E ratio?
If the firm requires financing to maintain capex every period than thats a bad sign about the firm that should lower the price. Assuming the decrease in the numerator would be larger than the decrease in Earnings(bec. of interest) , the P/E ratio should go down
For the following "If you issue debt and are putting it into maintenance capex that'll likely increase your P/E ratio, " Did you mean to say that it would 'decrease' your P/E ratio?
If the firm requires financing to maintain capex every period than thats a bad sign about the firm that should lower the price. Assuming the decrease in the numerator would be larger than the decrease in Earnings(bec. of interest) , the P/E ratio should go down
I don't disagree with the answers above that advocate taking a nuanced approach to the question and explaining how debt issuance may impact valuation and multiples. However, I don't think it's wrong either to offer, on a generalized basis, that increasing a company's debt capitalization will lower it's P/E multiple.
Generally speaking, cost of debt is lower than a company's cost of equity, and in stylized corporate finance theory capital structure is irrelevant to firm value. Since debt's lower cost means it carries a higher "multiple" it stands to reason that increasing its weight in a firm's capital structure should reduce the multiple on the equity component. This further occurs as a function of the fact that by taking what used to be earnings and paying it out as a more senior fixed interest payment, the remaining earnings are more "risky" and should command a higher risk premium and therefore a lower multiple.
First of all , assume Equity value is the PV of future FCFE's. The debt will effect in a number of ways
1) The immediate FCFE will rise however FCFE in future years will fall as interest payments are due 2) Earnings will fall because of interest payments( lower numerator) 3) cost of equity will rise with higher D/E ratio( higher numerator)
The exact impact is therefore ambiguous in my view looked at this way. However I think it also depends on whether the addition debt is taking the company's Debt/ Equity ratio closer to their optimal point . If that's the case, the PE ratio shall rise in my view
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