Impact of debt on stock price

How does paying down debt impact a company's stock price? Obviously it reduces the perceived "riskiness" of the business so the earnings multiple could expand and it also increases EPS due to lower interest payments, so would it be correct to say that paying down debt ALWAYS leads to a higher stock price?

At the same time thinking of the EBITDA multiple, paying off the debt would lead to a lower multiple given EV declines, so would it be correct to assume that if for example a company was trading at 10x ebitda but has now paid off a large chunk of debt and is trading at 8x should still be valued at 10x?

Lastly, is there an "ideal" amount of debt a company should hold?

Thanks!

 
Best Response

The EV/EBITDA multiple wouldn't change because the metric is agnostic to capital structure. Paying down debt or buying back stock doesn't change the EV because you are using cash - i.e. cash and debt both decrease by the same amount, so net debt doesn't change.

P/E is a little more interesting, however. The theoretical perspective would be that there is an optimal capital structure, and when a company is too levered the P/E will drop to compensate for added risk. However, the balance sheet can also be underutilized, and that can depress the multiple as well. For example, an under-levered company can potentially take out debt to fund projects that can increase earnings growth. In that scenario, the P/E multiple is likely to increase with the added debt because the benefit of improved earnings power will more than offset the increased balance sheet risk.

 

Are you running analysis on valeant. Basically what guys are doing on that figuring IF the business is stable and buying 3-4 times fcf that it will appreciate as debt is paid off the next few years. EV flat over next few years but stock appreciates as it lowers debt.

 

Might be easier to think about this using another example...let's say you owned a house that was worth $1mm (the enterprise value). If it was 80% debt financed, debt would be $800k and equity would be $200k. If you paid down all of the debt tomorrow, the house is still worth $1mm (ie, the enterprise value doesn't change). It's just that your debt would now be $0 and your equity would be $1mm. So your equity went from $200k to $1mm. It's the same concept. Therefore, every dollar of debt paydown will increase your equity value by the same amount.

 

I like the way you have broken it down simply. SB for you. Just to add this is a process that is not black and white i.e there are assumptions tax is not occurred which in essence changes things on an LBO (as such pe ramp debt up as a tax shield - dont pay tax). Anyhow, relating back to the question, share price is derived via equity value from market equity and no of shares. In effect, a rise in debt increases debt obligations thus make return on equity smaller and shareholders less happy therefore decreasing the demand for the stock hence more number of shares reducing the share price. Apologies for the complex answer and I will apologize for the idiot above.

 

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