Let’s start with the most common response. When a company takes on more debt, it incurs additional interest expense so it has lower earnings and therefore the PE multiple increases. That’s how most candidates answer this question and unfortunately that’s incorrect.
It’s an arithmetic answer that fails to account for the equivalent change in Stock Price. Without the factors listed below, the Enterprise Value of the company stays the same, so by taking on additional debt, Equity Value actually declines. Equity Value = Stock Price (x) Shares Outstanding. And since Shares Outstanding doesn’t change when a company increases debt, the Stock Prices also goes down, canceling out the decline in earnings.
The correct answer here is that the effect on PE is indeterminate because there are multiple levers pulling the multiple in different directions as a company takes on debt. The interviewer is looking for you to identify these drivers of valuation multiples.
So let’s jump in.
Factors Driving PE Multiple Up
WACC Curve The Enterprise Value of a company is the present value of all the future unlevered free cash flow it will generate discounted back using WACC. While future unlevered free cash flow isn’t affected by taking on additional debt, WACC is. The relationship between WACC and the debt amount is a U-Curve (Exhibit 1). In the beginning, because cost of debt is so much lower than cost of equity, increasing debt “averages down” the company’s WACC. When WACC decreases, the company’s future cash flow are worth more and so its Enterprise Value increases. The increase in Enterprise Value is translated into an increase in Equity Value and this incremental increase in Equity Value leads to a higher PE multiple.
Accelerated Growth In most instances, growth is the single biggest driver of valuation multiples. Investors are willing to pay a higher PE multiple for a higher growth business. By levering up with additional debt, companies can financially engineer an accelerated earnings growth. Take a look at Exhibit 2. By levering up with debt, the company will grow at a faster rate. So with higher growth, investors are willing to pay a higher PE multiple
Factors Driving PE Multiple Down
WACC Curve While the WACC curve can pull the PE multiple up, it can also push it down depending on how far the company is along the curve. As mentioned above, the relationship between WACC and debt amount is a U-Curve. While increasing debt in the beginning “averages down” the company’s WACC, taking on too much debt will cause the cost of debt and equity beta to increase dramatically, reflecting the increased financial risk of the business. At that point, WACC starts to rise and that decreases Enterprise Value. The decrease in Enterprise Value translates to a decrease in Equity Value and this incremental decrease in Equity Value leads to a lower PE multiple.
Restrictive Covenants Debt issuances can come with restrictive covenants that limit the company’s ability to reinvest into the business through CapEx or M&A With limited reinvestments in the business, the company might not be able to grow as fast and equity investors will pay a lower multiple for the business. Creditors want these covenants because they ensure that the company will have enough cash flow to repay them. However, these restrictions are often at the expense of equity holders.
So there you have it. Two levers pulling P/E up and two levers pulling it down.
Thanks for reading! Hope this enhances you understanding of valuation multiples. We’ll post more as part of our Technical Series and if there’re any specific questions you’d like us to cover, email us at info@10xebitda.com.
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FAQs
When a company takes on more debt, it incurs additional interest expense so it has lower earnings and therefore the PE multiple increases.
How does debt affect the PE ratio? ›
The effect of debt on the PE ratio is more complex. When a company borrows money to buy back shares this can lower a PE ratio. Here's why: The increase in debt reduces the company's market capitalisation and the number of shares shrinks.
Does raising debt change equity value? ›
Debt is often cheaper than equity, and interest payments are tax-deductible. So, as the level of debt increases, returns to equity owners also increase — enhancing the company's value. If risk weren't a factor, then the more debt a business has, the greater its value would be.
What happens to a company's WACC if the company raises debt what might make your answer wrong? ›
If the financial risk to shareholders increases, they will require a greater return to compensate them for this increased risk, thus the cost of equity will increase and this will lead to an increase in the WACC. more debt also increases the WACC as: gearing. financial risk.
Why does EPS increase with debt? ›
Interest Expense:
One of the reasons why EPS may rise with an increase in debt is that debt usually comes with interest expense. When a company takes on debt, it must pay interest on that debt. This interest expense is deducted from the company's earnings before calculating EPS.
Does PE ratio account for debt? ›
The P/E ratio does nothing to factor in the amount of debt that a company carries on its balance sheet.
How does debt-to-equity ratio affect cost of equity? ›
If the debt to equity ratio gets too high, the cost of borrowing will skyrocket, as will the cost of equity, and the company's WACC will get extremely high, driving down its share price.
What happens when a company raises debt? ›
Increasing debt causes leverage ratios such as debt-to-equity and debt-to-total capital to rise. Debt financing often comes with covenants, meaning that a firm must meet certain interest coverage and debt-level requirements.
What happens when a company increases debt? ›
While increasing debt in the beginning “averages down” the company's WACC, taking on too much debt will cause the cost of debt and equity beta to increase dramatically, reflecting the increased financial risk of the business. At that point, WACC starts to rise and that decreases Enterprise Value.
What happens to a company when its debt to assets ratio increases? ›
The higher a company's debt-to-total assets ratio, the more it is said to be leveraged. Highly leveraged companies carry more risk of missing debt payments should their revenues decline, and it is harder to raise new debt to get through a downturn.
Debt to Asset Ratio (DAR) and Debt to Equity Ratio (DER) have simultaneous effect on Earning Per Share (EPS). Keywords: DAR (Debt to Asset Ratio), DER (Debt to Equity Ratio), EPS (Earning Per Share).
How does issuance of debt impact EPS? ›
For a company, debt is an effective tool to raise funds for expansion and development without diluting ownership control. Over exposure to equity for financing capex could lead to a fall in earnings per share (EPS).
How does increasing debt affect shareholders? ›
As debt increases, shareholders require higher returns since they face higher financial risk. This higher financial risk results from spreading the firm's business risk over a proportionately smaller equity base.
What affects PE ratio? ›
P/E ratio is affected by several factors some of the common factors are - earnings and sales growth of the firm, the risk (or volatility in performance), the debt-equity structure of the firm, the dividend policy, and the quality of management.
How does debt affect stock price? ›
Generally, too much debt is a bad thing for companies and shareholders because it inhibits a company's ability to create a cash surplus. Furthermore, high debt levels may negatively affect common stockholders, who are last in line for claiming payback from a company that becomes insolvent.
What is debt-to-equity ratio PE? ›
The debt to equity ratio (D/E) is calculated by dividing the total debt balance by the total equity balance, as shown below. In Year 1, for instance, the D/E ratio comes out to 0.7x. And then from Year 1 to Year 5, the D/E ratio increases each year until reaching 1.0x in the final projection period.
Why do PE firms use debt? ›
PE firms play with other people's money – from investors in its funds to creditors who provide loans. Leverage magnifies investment returns in good times – and PE firms collect a disproportionate share of these gains. But if the debt cannot be repaid, the company, its workers, and its creditors bear the costs.
