Infuriating Technical

Really simple one that I've gotten a couple different places: two firms otherwise identical, one has more leverage, is its P/E higher or lower? (Yes, I've searched every WSO thread about this, and Here are my competing thoughts on this:

Denominator: EBITDA is the same, levered firm has tax-effected interest expense so overall net income and EPS are lower. This seems to be pretty clear.

Numerator: Here is where I get my head all jumbled up. Some different perspectives I've taken are:
--if proceeds from debt are used to repurchase shares, then EV is the same, equity value is cut, but so are FDSO/NOSH proportionally so price stays the same

--adding leverage means the required rate of return for equity is higher, meaning the FCFE's are discounted at a higher cost than before, leading to a lower equity value and price

--adding leverage means the expected returns to equity are higher, because debt's share of project returns are capped at the cost of debt. If investors expect a higher return on equity, they will bid the price up due to higher demand for the stock. Alternatively, higher return on equity means higher FCFE, though I'm not sure what the interaction with the higher cost of equity would net out the equity value/price to be.

I think I've BS'ed some version of all three of these explanations in interviews without much indication as to the "right" answer. Can someone advocate for a "right" approach and indicate why my alternative thoughts are wrong? Much appreciated.

 

My 2 cents…I would keep it simple. More leverage means net income will be lower because of interest expense. Since P/E is Price/Earnings per share - which is the same thing as equity value/net income (not sure what you're trying to do with EBITDA), the P/E of the levered firm will be higher.

 
ibanking11:

My 2 cents...I would keep it simple. More leverage means net income will be lower because of interest expense. Since P/E is Price/Earnings per share - which is the same thing as equity value/net income (not sure what you're trying to do with EBITDA), the P/E of the levered firm will be higher.

This is the right way to think about it. End of story.

 
Waymon3x6:
ibanking11:
My 2 cents...I would keep it simple. More leverage means net income will be lower because of interest expense. Since P/E is Price/Earnings per share - which is the same thing as equity value/net income (not sure what you're trying to do with EBITDA), the P/E of the levered firm will be higher.

This is the right way to think about it. End of story.

Nah, this is completely wrong. It looks at the movement in only one variable, namely the denominator (which does decrease) but ignores the effects of the numerator. As you reduce the number of shares, the market cap will decline also. It also ignores all other relevant variables, such as interest tax shield and borrowing costs.

Standard WSO crap.

“Elections are a futures market for stolen property”
 
Esuric:
Waymon3x6:
ibanking11: My 2 cents...I would keep it simple. More leverage means net income will be lower because of interest expense. Since P/E is Price/Earnings per share - which is the same thing as equity value/net income (not sure what you're trying to do with EBITDA), the P/E of the levered firm will be higher.
This is the right way to think about it. End of story.

Nah, this is completely wrong. It looks at the movement in only one variable, namely the denominator (which does decrease) but ignores the effects of the numerator. As you reduce the number of shares, the market cap will decline also. It also ignores all other relevant variables, such as interest tax shield and borrowing costs.

Standard WSO crap.

Who said anything about reducing shares?

Also, your second point about reducing shares and its destructive effect on market cap does not hold water.

Market cap = price x shares outstanding.

If a company is buying back shares, assuming the shares are "cheap", investors will applaud management as they appear to be more shareholder friendly. Investors will buy the stock because they are bullish on the company's valuation. The price of the stock increases resulting in a higher market cap.

Assuming the shares are expensive, investors will not be as excited and will sell. Management is destroying shareholder value, by spending capital on an expensive buyback when it could be spent elsewhere and generate a higher return for shareholders. Investors will sell their shares, the stock will fall, and market cap will thus decline.

My overall point - reducing the amount of shares does not always lead to a declining market capitalization.

 
Waymon3x6:
Esuric:
Waymon3x6: ibanking11: My 2 cents...I would keep it simple. More leverage means net income will be lower because of interest expense. Since P/E is Price/Earnings per share - which is the same thing as equity value/net income (not sure what you're trying to do with EBITDA), the P/E of the levered firm will be higher.
This is the right way to think about it. End of story.
Nah, this is completely wrong. It looks at the movement in only one variable, namely the denominator (which does decrease) but ignores the effects of the numerator. As you reduce the number of shares, the market cap will decline also. It also ignores all other relevant variables, such as interest tax shield and borrowing costs.
Standard WSO crap.

Who said anything about reducing shares?

Also, your second point about reducing shares and its destructive effect on market cap does not hold water.

Market cap = price x shares outstanding.

If a company is buying back shares, assuming the shares are "cheap", investors will applaud management as they appear to be more shareholder friendly. Investors will buy the stock because they are bullish on the company's valuation. The price of the stock increases resulting in a higher market cap.

Assuming the shares are expensive, investors will not be as excited and will sell. Management is destroying shareholder value, by spending capital on an expensive buyback when it could be spent elsewhere and generate a higher return for shareholders. Investors will sell their shares, the stock will fall, and market cap will thus decline.

My overall point - reducing the amount of shares does not always lead to a declining market capitalization.

The multiple would have to increase dramatically in order for the market cap to rise with a simultaneously reduction in shares outstanding. Your hypothetical scenario assumes a monstrous, unprecedented market dislocation.

“Elections are a futures market for stolen property”
 
Esuric:
Waymon3x6:
Esuric: Waymon3x6: ibanking11: My 2 cents...I would keep it simple. More leverage means net income will be lower because of interest expense. Since P/E is Price/Earnings per share - which is the same thing as equity value/net income (not sure what you're trying to do with EBITDA), the P/E of the levered firm will be higher.
This is the right way to think about it. End of story.
Nah, this is completely wrong. It looks at the movement in only one variable, namely the denominator (which does decrease) but ignores the effects of the numerator. As you reduce the number of shares, the market cap will decline also. It also ignores all other relevant variables, such as interest tax shield and borrowing costs.
Standard WSO crap.
Who said anything about reducing shares?
Also, your second point about reducing shares and its destructive effect on market cap does not hold water.
Market cap = price x shares outstanding.
If a company is buying back shares, assuming the shares are "cheap", investors will applaud management as they appear to be more shareholder friendly. Investors will buy the stock because they are bullish on the company's valuation. The price of the stock increases resulting in a higher market cap.
Assuming the shares are expensive, investors will not be as excited and will sell. Management is destroying shareholder value, by spending capital on an expensive buyback when it could be spent elsewhere and generate a higher return for shareholders. Investors will sell their shares, the stock will fall, and market cap will thus decline.
My overall point - reducing the amount of shares does not always lead to a declining market capitalization.

The multiple would have to increase dramatically in order for the market cap to rise with a simultaneously reduction in shares outstanding. Your hypothetical scenario assumes a monstrous, unprecedented market dislocation.

It's hypothetical to assume the company will buy back shares in the first place.

 
Waymon3x6:
Esuric:
Waymon3x6: Esuric: Waymon3x6: ibanking11: My 2 cents...I would keep it simple. More leverage means net income will be lower because of interest expense. Since P/E is Price/Earnings per share - which is the same thing as equity value/net income (not sure what you're trying to do with EBITDA), the P/E of the levered firm will be higher.
This is the right way to think about it. End of story.
Nah, this is completely wrong. It looks at the movement in only one variable, namely the denominator (which does decrease) but ignores the effects of the numerator. As you reduce the number of shares, the market cap will decline also. It also ignores all other relevant variables, such as interest tax shield and borrowing costs.
Standard WSO crap.
Who said anything about reducing shares?
Also, your second point about reducing shares and its destructive effect on market cap does not hold water.
Market cap = price x shares outstanding.
If a company is buying back shares, assuming the shares are "cheap", investors will applaud management as they appear to be more shareholder friendly. Investors will buy the stock because they are bullish on the company's valuation. The price of the stock increases resulting in a higher market cap.
Assuming the shares are expensive, investors will not be as excited and will sell. Management is destroying shareholder value, by spending capital on an expensive buyback when it could be spent elsewhere and generate a higher return for shareholders. Investors will sell their shares, the stock will fall, and market cap will thus decline.
My overall point - reducing the amount of shares does not always lead to a declining market capitalization.
The multiple would have to increase dramatically in order for the market cap to rise with a simultaneously reduction in shares outstanding. Your hypothetical scenario assumes a monstrous, unprecedented market dislocation.

It's hypothetical to assume the company will buy back shares in the first place.

...? Well that's what we're discussing.. What would reasonably happen if the entity purchased shares by issuing debt. Your response is unreasonable - it makes outlandish assumptions and ignores key variables.

“Elections are a futures market for stolen property”
 
Best Response
Esuric:
Waymon3x6:
Esuric: Waymon3x6: Esuric: Waymon3x6: ibanking11: My 2 cents...I would keep it simple. More leverage means net income will be lower because of interest expense. Since P/E is Price/Earnings per share - which is the same thing as equity value/net income (not sure what you're trying to do with EBITDA), the P/E of the levered firm will be higher.
This is the right way to think about it. End of story.
Nah, this is completely wrong. It looks at the movement in only one variable, namely the denominator (which does decrease) but ignores the effects of the numerator. As you reduce the number of shares, the market cap will decline also. It also ignores all other relevant variables, such as interest tax shield and borrowing costs.
Standard WSO crap.
Who said anything about reducing shares?
Also, your second point about reducing shares and its destructive effect on market cap does not hold water.
Market cap = price x shares outstanding.
If a company is buying back shares, assuming the shares are "cheap", investors will applaud management as they appear to be more shareholder friendly. Investors will buy the stock because they are bullish on the company's valuation. The price of the stock increases resulting in a higher market cap.
Assuming the shares are expensive, investors will not be as excited and will sell. Management is destroying shareholder value, by spending capital on an expensive buyback when it could be spent elsewhere and generate a higher return for shareholders. Investors will sell their shares, the stock will fall, and market cap will thus decline.
My overall point - reducing the amount of shares does not always lead to a declining market capitalization.
The multiple would have to increase dramatically in order for the market cap to rise with a simultaneously reduction in shares outstanding. Your hypothetical scenario assumes a monstrous, unprecedented market dislocation.
It's hypothetical to assume the company will buy back shares in the first place.

...? Well that's what we're discussing.. What would reasonably happen if the entity purchased shares by issuing debt. Your response is unreasonable - it makes outlandish assumptions and ignores key variables.

Every time there is a technical Q on WSO you always chime in, get shit wrong, over complicate things and take a far too academic line. Please stop.
"After you work on Wall Street it’s a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side.” - David Tepper
 
Esuric:
Waymon3x6:
Esuric: Waymon3x6: Esuric: Waymon3x6: ibanking11: My 2 cents...I would keep it simple. More leverage means net income will be lower because of interest expense. Since P/E is Price/Earnings per share - which is the same thing as equity value/net income (not sure what you're trying to do with EBITDA), the P/E of the levered firm will be higher.
This is the right way to think about it. End of story.
Nah, this is completely wrong. It looks at the movement in only one variable, namely the denominator (which does decrease) but ignores the effects of the numerator. As you reduce the number of shares, the market cap will decline also. It also ignores all other relevant variables, such as interest tax shield and borrowing costs.
Standard WSO crap.
Who said anything about reducing shares?
Also, your second point about reducing shares and its destructive effect on market cap does not hold water.
Market cap = price x shares outstanding.
If a company is buying back shares, assuming the shares are "cheap", investors will applaud management as they appear to be more shareholder friendly. Investors will buy the stock because they are bullish on the company's valuation. The price of the stock increases resulting in a higher market cap.
Assuming the shares are expensive, investors will not be as excited and will sell. Management is destroying shareholder value, by spending capital on an expensive buyback when it could be spent elsewhere and generate a higher return for shareholders. Investors will sell their shares, the stock will fall, and market cap will thus decline.
My overall point - reducing the amount of shares does not always lead to a declining market capitalization.
The multiple would have to increase dramatically in order for the market cap to rise with a simultaneously reduction in shares outstanding. Your hypothetical scenario assumes a monstrous, unprecedented market dislocation.
It's hypothetical to assume the company will buy back shares in the first place.

...? Well that's what we're discussing.. What would reasonably happen if the entity purchased shares by issuing debt. Your response is unreasonable - it makes outlandish assumptions and ignores key variables.

Here is the question:

"You have two firms otherwise identical, one has more leverage, is its P/E higher or lower?"

Why would you ever start to talk about share repurchases through issuing debt? That does not answer the question at all.

I quoted the correct answer, which you pointed out as being wrong. We can go back and forth on this but at the end of the day it's a very simple answer. Please stop posting over-complicated and erroneous answers.

 
verzen:

You're definitely over-complicating things.

P/E is not independent of capital structure so: more leverage => more interest expense => lower net income => higher P/E ratio since the denominator decreases.

This seems entirely correct, but do we just assume that price is kept constant due to "otherwise identical" or do you change the price due to the fact that the companies have an inequality in earnings?

 

The true answer is that it technically depends on your cost of debt.

Let's look at a simple illustration. A company generates unlevered free cash flow (or any other capital structure neutral metric, like EBITDA), such that the value of the enterprise is $1bn. In scenario A, let's assume zero leverage, and therefore the company is purely capitalized through equity. Assume that net income is $80mm, resulting in a P/E of 12.5x.

In scenario B, the company is heavily levered - let's assume capitalization of 60% debt, 40% equity. Therefore $600mm of debt + $400mm of equity = same $1bn enterprise value. Now, if cost of debt (i.e., the avg. interest rate on the debt) is 5%, net income is now $80mm - $30mm of int. expense= $50mm, leaving you with a P/E of 8x. However, if a cost of debt is 10%, net income would be $20mm, resulting in a P/E of 20x.

Intuitively, this is because when there is a higher return required by credit investors, there is generally a corresponding higher return expected by equity investors. When the cost of debt exceeds the return on equity implied by the P/E prior to any leverage, P/E will increase. Otherwise, P/E will decrease.

The above only holds true when the unlevered and levered company are otherwise identical with respect to enterprise value. In the real world of course, when public companies take on additional debt / increase leverage, it's usually to finance capital allocations that are supposed to increase enterprise value (e.g., through organic growth or m&a). In this case, the pre and post - levered companies would not be directly comparable.

 

I think this is an over complication as well. 1bil market chap / 80mil NI gives the 12.5 P/E ratio. P/E gets lower as more debt is added. 400/80 equals a P/E ratio of 5. You can't really account for Anything else because the question only asks between a leveraged and non leveraged firm who will have a higher P/E. You could go into that discussion on cost of debt, but you can't even be certain that market cap would stay the same if your NI was 50m or 20m.

 

Look chaps, the question is obviously regarding interest expense and its effect, ceteris paribus, on the EPS.

We can all over complicate this and as with every alteration to a company has secondary, tertiary etc... affects on the discount rate and cash flow properties.... But for an interview, noting the above and alluding to the further complexities which the interviewer can dig on if required is acceptable. If the question is merely a prop to for the interviewer to see how you think, they'll keep digging at this point.

"After you work on Wall Street it’s a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side.” - David Tepper
 

Technically, if you take the question in it's most literal sense, then P/E would be equal. Everything(Didn't see an exclusion for P/E just for leverage) is the same. Even if you don't wanna go that far same thing for mps/eps. So, all you people that know way more than me are wrong.

(if forced to choose from the explanations given, I'd choose higher p/e because that only requires one assumption that net income would lower while everything else stays the same.)

 
anonymousbro:

Technically, if you take the question in it's most literal sense, then P/E would be equal. Everything(Didn't see an exclusion for P/E just for leverage) is the same. Even if you don't wanna go that far same thing for mps/eps. So, all you people that know way more than me are wrong.

(if forced to choose from the explanations given, I'd choose higher p/e because that only requires one assumption that net income would lower while everything else stays the same.)

Ding
"After you work on Wall Street it’s a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side.” - David Tepper
 

Don't over complicate the basics. "Otherwise identical." The only thing you change is the denominator. Assume the same share price and clearly state to the interviewer that you are making this assumption. They want to see how you think and you're knowledge of accounting / capital structure. Let them probe deeper then by making further assumptions for you.

 

I've had this question on an M&A midterm which helped prepare me for when I was asked this while interviewing for buy side, not that this matters, but here is your answer:

Assume the company sweeps all of its earnings to pay dividends; that is, dividends = Earnings.

Consequently, you use a dividend discount model to value the firm. Leverage will be captured in the beta portion of CAPM.

equity value or "Price" = forward dividend or "earnings"/(cost of equity - perpetual growth rate)

"Price"/"Earnings" = 1/(cost of equity - growth rate)

As leverage increases, beta increases, cost of equity increases, denominator increases, P/E decreases.

Think about it, would you pay a higher or lower multiple for a business that is "riskier" by having more leverage? Lower multiple.

Hope this helped, guys. It is just an academic exercise.

My posts will be fraught with grammatical errors since I post from my phone. I will try my best not to post an incoherent babble.
 

As others have alluded to I would answer as follows:

All else equal the PE will increase as earnings are lower due to interest expense.

In reality, the movement will also depend on how STOCK price changes which is not a straightforward matter. Usually an increase in leverage will lead to a lower market cap as the risk is greater to equity holders but I would argue that at very low levels of leverage an increase in borrowings could actually be a positive as there is not a great risk of financial distress and you benefit from the tax shield.

 

Lots of noise up above. Not going to read all of it. If someone has answered adequately, than apologies.

My two cents: Like any hard interview question, it's important to have a framework.

Assumptions: Assume EV stays constant. Two companies (A and B) both have EV 1000 and no leverage to start. Let's simplify and say EBT is 100 for both companies. Assume 30% tax rate. Both companies have net income of 70

P/E is 1000/70 or 14.3x

Implied ke is 70/1000 (inverse of PE, cost / return per dollar earnings) or 7%

Simple Case: Lever up B and see what happens Assume kd of 5% (should be a little less than 7% - this matters later)

Raise 200 of debt for B EV is 1000 Debt is 200 equity value is 800 EBT = 100 - 200 x 5% (or 10) = 90 Net income = 63

P/E = 800 / 63 = 12.7x

P/E multiple goes down.

Backcheck: does this make sense? Layman's explanation: For the same amount of earnings, I'm willing to pay more for the unlevered company than the levered company. I think this makes sense. By levering the company, you are making each dollar of earnings more "risky".

Where this relationship breaks down (if things get more "complicated"): I mentioned how kd was 5%. As you lever up more debt holders in a real world scenario will demand more return as they take on more equity like risk. As a result, your ke (cost / return of equity) [goes up and your earnings] get cheaper (P/E multiple goes down) and your kd goes up. If you plot out WACC for various debt levels in a real world scenario, you get a parabola as debt increases. The optimal capital structure is at the bottom of the curve.

But for a SIMPLE case (not a overly levered or distressed company), I think this is accurate. Happy to take any feedback if there is something I've missed or some assumption doesn't make sense.

 

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