We take a look at how to compare two companies with different levels of debt.
A good few companies today are sitting on quite a lot of debt, and that scares a lot of investors, adding risk to the equation and lowering the price people are willing to pay for the shares as a result.
But debt isn't necessarily a bad thing, and while some companies have got into debt through misfortune or mismanagement, others have deliberately chosen to fund their businesses through debt. If a company can earn more extra cash using borrowed money than it has to pay in interest to service the loan, the extra is a boost to shareholders' earnings -- the company's profits are geared up. (But, of course, if the extra profits fail to exceed interest payments, the debt is losing the company money).
How do we compare?
Now, all that's well and good, but it doesn't half make it tricky to compare companies with different levels of debt, as we saw last week when I looked at the latest figures from a handful of brewers.
When comparing companies in the same sector, the P/E ratio is often used -- it has its limitations, but if two companies are in the same line of business, then we often assume that the similarities are enough for a P/E comparison to make some sense. But look at Young & Co's Brewery (LSE: YNGN) and Greene King (LSE: GNK), both very much in the same business, and both of which have recently reported pretty healthy interim results.
But Young's is on a forward P/E of 16 while Greene King's stands at a lowly 9. Part of the difference is debt -- Young's carries debt of less than a third of its total market capitalisation, while Green King's debt stands at one and a half times its market cap.
The P/E ratio takes no notice of debt, as the "Earnings" part only counts what's left after interest on debt (and other stuff like tax, etc) has been paid. That's fine for comparing what you have to pay to buy a share with what you're going to get in earnings, but with highly indebted companies we also need to know how efficiently the debt-funded part of the business is performing so we can tell whether it's worth taking the risk -- we need a measure of the total performance of the company, including the shareholder-funded and deb-funded parts of the business.
And that's where Enterprise Value comes in.
Rather than just looking at the market capitalisation of a company (which is effectively what the P/E looks at when using the Price), the Enterprise Value counts the debt-funded part too, and provides the price you'd have to pay to buy and fully own, without debt, the total enterprise.
So to get the Enterprise Value, we add a company's total debt to its market capitalisation, because we would have to pay that back too to fully own it, in addition to actually buying all the shares. And we then subtract any cash on its books, as we'd effectively get that back. Technically, we also need to add the values of any preference shares and minority interests, as we'd have to buy those out too (though for many companies those are relatively small, and we can still get a useful measure by just adding net debt to market cap).
Compare with earnings
Once we have the Enterprise Value, we need some measure of earnings with which to compare it, and the most commonly-used figure is EBITDA , which is short for earnings before interest, tax, depreciation and amortisation. That's because this counts the total earnings attributable to both the shareholder-funded part of the company and the debt-funded part.
If we then divide the Enterprise Value figure by EBITDA (from the company's latest report), we get the EV/EBITDA ratio, often known as the Enterprise Multiple, and that gives us a way to compare companies that have different levels of debt (or cash), but which are otherwise similar.
We should want to see a lower Enterprise Multiple for companies with greater debt (in the same way that, other things being equal, we prefer a lower P/E), as to be worth carrying, the debt needs to generate a disproportionately higher level of profits.
It's worth noting that for P/E comparisons, we're using per-share measures, but for Enterprise Value comparisons we're using whole-company measures, but as we are calculating ratios it doesn't matter which way we do it (and, of course, there are no readily-available per-share measures of enterprise value and pre-interest earnings).
Now, how do our two brewers stack up? Using the figures from last week, we get the following...
(* EBITDA estimated from interim statements
and excludes exceptional items)
Just as it has a lower P/E, Greene King has a similarly lower Enterprise Multiple -- but the gap is a lot narrower suggesting there isn't as much difference in the underlying valuations as there first appears.
Both valuations look relatively fair -- one company is paying out more in dividends and so is more highly rated by investors for its immediate returns, while the other is using its profits to pay down debt which is not especially profitable (resulting in a lower dividend), and hopefully boosting future earnings.
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