The Levered P/E Ratio

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. Since the original Modigliani–Miller study in the 1950s, a vast literature has accumulated on the role of debt in corporate valuation. Many of the studies focus on incorporating the effects of taxes, bankruptcy costs, credit spreads, and inflation in the basic M&M framework. Virtually all of the academic works proceed from the vantage point of corporate finance by ascertaining how various debt levels affect a company's value—that is, the effects of adding debt to a previously unlevered company. To an investment analyst, however, the company (in medical terminology) “presents” itself as already having certain observable growth characteristics, with the required funding supplied by a combination of equity and debt. That is, the issue is 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 fundamental shift in vantage point leads to surprisingly different results. The corporate finance studies reveal that increasing debt loads leads to only moderate valuation shifts and that such shifts can be, depending on the circumstances, either upward or downward. In contrast, when the focus is on the parameters the company presents to the marketplace, sensitivity to the leverage ratio is so high that leverage can significantly alter the company's theoretical P/E valuation. Moreover, from this vantage point, the P/E is always lower than the value obtained by use of the standard Gordon growth formula.This sensitivity can be illustrated by considering three companies, each of which retains 40 percent of earnings and is achieving 8 percent growth. The only difference among them is that the first company is debt free, the second has a debt ratio of 40 percent, and the third has a debt ratio of 50 percent. Suppose that the market discount rate for the unlevered company is 10 percent and the interest rate is 6 percent. Using the basic Gordon model with these assumed values, one finds that the theoretical P/E for the debt-free company is 30; the 40 percent debt load of the second company drives its theoretical P/E down to 23; and the third company, with the slightly higher 50 percent debt ratio, finds its theoretical P/E cut to 20. The comparison between the second and third companies may be a more realistic gauge of the effect of varying debt levels within a given market sector than a comparison between a debt-free company and a leveraged company.In practice, many other considerations, such as taxes, act as confounding factors on these effects. Nevertheless, the widespread and increasing role of debt in corporate life suggests that leverage factors should play a larger role in the analytical process. This concern is particularly relevant today because once the debt ratio rises beyond the 50 percent level—which has become quite common in today's financial marketplace—the incremental impact of additional debt grows at a rapidly accelerating pace.