The Levered P/E Ratio

The levered P/E ratio

Martin L Leibowitz
2,425 words
1 November 2002
Financial Analysts Journal
68
Volume 58, Issue 6; ISSN: 0015-198X
English
Copyright (c) 2002 ProQuest Information and Learning. All rights reserved. Copyright Association for Investment Management and Research Nov/Dec 2002

A vast literature examines the role of debt in corporate valuation, but most of these works proceed from the vantage point of corporate finance (i.e., ascertaining the effects of adding debt to a previously unlevered company). The investment analyst, however, confronts an already-levered company with already-levered return parameters. The analyst's challenge is to estimate the stock's theoretical value by inferring the company's underlying structure of returns. This shift in vantage point leads to results about the effect of leverage that are surprisingly different from the results of studies from the corporate finance angle. Whereas corporate finance studies find only a moderate effect of leverage, when viewed from the analyst's perspective, a company's value has such a high degree of sensitivity to the leverage ratio that it can significantly alter the theoretical P/E valuation.

Moreover, from the analyst's vantage point, leverage always moves the P/E toward a lower value than that obtained from the standard formula.

The classic Modigliani-Miller study (1958a) gave rise to a vast literature on the role of debt in corporate valuation (Miller 1977; Modigliani 1982; Modigliani and Cohn 1979; Modigliani and Miller 1958b, 1959, 1963a, 1963b; Myers 1974, 1984; Taggart 1991). Many of these studies focused on incorporating the effects of taxes, bankruptcy costs, credit spreads, and inflation into the basic Modigliani-Miller framework relating cost of capital, corporate finance, and the theory of investment.1 Virtually all of these academic works, however, proceed from the corporate finance vantage point (i.e., ascertaining how various debt levels affect the company's value).

In contrast, there is a paucity of work that addresses the problem from the market perspective of an investment analyst. To describe the market's perspective using a medical analogy, one might say a company "presents" a variety of symptoms that can reveal an underlying condition. In other words, it has certain observable growth characteristics, with the required funding supplied by a given combination of equity and debt. The investment analyst's role is akin to that of a clinical practitioner who has the challenge of diagnosing the underlying condition from the "presented" symptoms. And just as the conjunction of two symptoms may have far more important implications than either one by itself, so the combination of a given growth rate and a given equity absorption rate can, depending on the magnitude of debt incorporated in the funding process, have vastly different valuation effects. The analyst's problem is to estimate the stock's theoretical value, typically in terms of some comparative metric, such as a P/E.

In light of the growth of corporate debt in modern financial markets, as shown in Figure 1, it is surprising that so little attention has been paid to the issue of the P/E of the already-levered company. In the practitioner literature, there is essentially a total vacuum on how various levels of debt interact with such key valuation measures as P/E. Clearly, market participants need to incorporate this debt effect more routinely into analyses at both the micro level (e.g., cross-sectional comparison of individual stocks) and the macro level (e.g., the role of the recent surge in corporate debt on the aggregate market risk premium). Indeed, given the evolving role of corporate debt, historical analysis of the equity risk premium might be better framed in terms of the more fundamental risk associated with a notionally unlevered equity position.

In a 1991 study with Kogelman, we explored the debt problem within the franchise value framework. Although we did target the P/E, this study still followed the corporate finance approach of using the return parameters of the unlevered company as the starting point. Our basic finding was that the use of leverage produces two effects that tend to offset each other. Moreover, it turned out that debt could increase or reduce the P/E, depending on the unlevered company's return structure. For normal levels of investment-grade debt, however, all of these P/E effects were relatively modest. Figure 1.

This finding may have been theoretically correct from a corporate finance viewpoint (i.e., the effect of leverage on a given company with known return characteristics). The problem encountered in investment analysis, however, is that of an already-- levered company with its already-levered return parameters. In this setting, the analyst must infer the company's underlying fundamental structure of returns.

The corporate finance approach deals with a single company-that is, exploring the impact on a company of varying degrees of leverage. In contrast, this current article looks at a number of distinct companies that display the same overt characteristics but differ in their debt levels. This shift in vantage point leads to results that are surprisingly different from those of the earlier corporate finance study, which found only a moderate impact from increasing debt loads. The present study, by focusing on the parameters that companies present to the marketplace, finds such a high degree of sensitivity to the leverage ratio that it can significantly alter a company's estimated P/E valuation. Moreover, in this market context, the P/E always moves toward a lower theoretical value than that obtained from the standard formula.

This sensitivity can be illustrated through three numerical examples. Consider three companies, each retaining 40 percent of earnings and achieving 8 percent growth. The only differences among the companies are that the first is debt free, the second has a debt ratio of 40 percent, and the third has a somewhat higher debt ratio, 50 percent. Suppose that the market discount rate for the unlevered company is 10 percent and the interest rate is 6 percent. (This article uses these same values for the retention rate, the earnings growth, the market rate, and the interest rate in all the numerical examples except when specifically noted.) Using the basic Gordon model with these assumed values, one finds that the theoretical P/E for the debtfree company is 30. In contrast, the 40 percent debt load of the second company drives its theoretical P/E down to 23. An even more realistic comparison would be that the company's 40 percent debt load is representative of a particular market sector. To illustrate the continued sensitivity to debt levels beyond the sector average P/E of 23, consider the third company, which has identical earnings retention and growth characteristics but has a slightly higher debt load, 50 percent. In this case, the theoretical P/E drops to 20, a significant difference from the sector average.

In fairness, these examples tend to overstate the magnitude of the leverage effect. In practice, a number of other considerations, such as the presence of taxes, act as moderating factors. Nevertheless, the widespread and increasing role of debt in modern financial markets suggests that leverage factors should play a larger role in the analytical process. This concern may be particularly relevant in today's market because the valuation impact of debt grows at a rapidly accelerating pace once debt increases beyond the 50 percent level.

The Gordon Growth Model

The two most obvious effects of debt are (1) the reduction of earnings because of interest charges and (2) the intrusion of the creditor's claim on the company's assets. Although the 1991 franchise value study (Leibowitz and Kogelman) took these two effects into account, this earlier work overlooked an important third effect-how debt changes the appearance of the company's characteristics. This third effect is the focal point of the present article.

The starting point for this analysis is the framework of the basic Gordon growth model (Williams 1938; Gordon 1962, 1974; Damodaran 1996).3 Although clearly a simplistic formulation, the Gordon model and its multiphase variants remain in common use by market participants. Moreover, the basic Gordon model serves as a short-term equilibrium condition for P/E stability.

For an unlevered company, the Gordon model expresses a company's value, P', as

Conclusions

When a market perspective is applied to the effect of leverage on P/E, the results are quite different from the results of taking a corporate finance point of view. From a corporate finance study, leverage has a modest P/E effect and one that can move the P/E slightly up or down. From a market perspective, in contrast, the effect of leverage can be significant and increasing leverage always moves the P/E downward. Although paradoxical, these results are theoretically consistent; the critical difference is the vantage point. From the corporate finance vantage point, the given parameter is the company's fundamental unlevered return. From the market vantage point, the levered return is already given and a debt ratio is specified. In such a case, as the debt ratio increases, the given levered ROE implies an ever-- lower fundamental unlevered ROA. The result is a lower economic value and, hence, uniformly lower theoretical P/Es. This situation-not the situation of an unlevered company that faces a corporate manager or an investment banker-is what typically confronts the securities analyst. For this reason, market analysts should pay careful attention to a company's debt structure as they try to determine the appropriate theoretical P/E for valuation purposes.

This article reports a purely analytical study by the author using hypothetical examples for illustrative purposes only. It is not intended to be descriptive of any individual form or specific class of equities, and it should not be construed as representing the official organizational position of TIAA-CREF The author would like to express his gratitude for many helpful suggestions from Eric Fisher, Brett Hammond, Leo Kamp, Stanley Kogelman, Jack Treynor, and Yuewu Xu.

Martin L. Leibowitz is vice chairman and chief investment officer at TIAA-CREF, New York.

Footnotes:

1. A forthcoming paper by Adsera and Vinolas attempts to integrate these factors into a single formulation.

2. Of course, a myriad of additional considerations surround the presence of debt-tax effects, credit spreads, potential bankruptcy costs, the various intervention options available to debtholders, and so on. For clarity, however, these complications are avoided here and the focus is on how the

observed characteristics of a levered company affect its return parameters within a totally tax-free environment.

3. A more generalized model is deferred to a later study.

4. For the development, see Leibowitz (2002).

5. Note that the term "risk premium" is used here only as the convenient way to characterize the difference between the discount rate on (unlevered) equity and the corporate debt

rate: There is neither a presumption nor an implication of any specific "risk model."

6. Note, however, that this approach works only within the simplistic framework of the basic Gordon model. Unlike the development earlier in this article, it cannot be readily

applied to more general cash flow patterns without encountering problems of circularity.

7. The derivation of the P/E computation for this tax case is available from the author upon request.

8. See the "Levered Valuation with Differential Returns" section in Leibowitz (2002).

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