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!
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.
So would an ok rule of thumb to figure out whether a company is under-levered be to compare to peers and see how much leverage they've taken on? Or would there be a better way of doing this?
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.
How is a stock price affected when a company swaps debt for equity (Originally Posted: 06/26/2018)
A public company I have followed for four years is currently on a restructuring spree. They never went bankrupt, but were close at one point. They've since hammered down the amount of debt by swapping it for equity, essentially diluting the existing shareholders.
I understand how a balance sheet works and how the liabilities decrease, but SE and Assets increase so it all balances.
But historically, how does this move affect the stock price? I realize now the company is less "risky" with less debt and other factors can explain an increase or decrease in the stock price, I'm just looking for the by in large explanation. Thanks!
This isn't right. $800K of cash to pay off debt doesn't just come out of thin air. If you had $800K of cash available, then your equity would have been $1M the whole time because net debt was $0 even when gross debt was $800K.
I guess you don't own a home....or have ever worked on an LBO....or have ever invested in a company that was deleveraging.
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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