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How Leverage Distorts The Price Earnings Ratio

The Price Earnings Ratio is considered one of the central ratios of the investing world. One of the first and most basic indicators it is vital in it's informative quality and gracious in simplicity.

What the Price Earnings Ratio essentially tells you is how expensive a share is relative to it's earnings power. I don't want to dwell for too long as most will be familiar with this concept but a quick example - a 10x ratio means a share price is worth 10 times the annual net income attributable to that share.

By trawling these forum's I have noticed a lot of people basic entire valuations based on comparable PE's without looking at the debt load of each company. By looking at two companies with different debt to equity ratios, the PE ratio essentially becomes useless and any attempt to use this as a basis of value may lead to some nasty surprises.

So we have Wrigleys and Levermax. Both companies have just been set up to produce chewing gum.

Mr. Wrigley is a rather cautious man and decides to issue 80 x $1 shares and raise $20 from his bank. The company therefore has $80 equity, $20 debt and $100 in cash.

Levermax is a collection of unscrupulous ex-bankers who believe they can crack the chewing gum market. Since they lost their bonuses in the 2008 implosion, they will only issue 20 x $1 and rely on the bank for $80 in debt.

The bank believes in both businesses and so they have issued all the debt at 10% per annum. The unscrupulous bankers rely on Wrigley's to understand the market and so decide to copy his order patterns.

As a result, both companies spend $50 of their cash to purchase 250 sticks of gum. Their assets are now Inventory $50 and Cash $50.

Because of the halitosis crisis of 2013, the companies can charge 50c per stick of gum (which cost 20c each) and both companies sell their entire stock!

Both companies are completely identical down to the EBIT line but as you remember Levermax took out a massive $80 loan meaning that they have to pay $8 interest while conservative Mr.Wrigley only pays $2. Despite a small tax shield, Wrigley's nets $16.10 Profit after tax while the LeverMax conglomerate only earns $11.90.

At this point, the two companies have run the exact same business with different capital structures except Mr Wrigley has generated 35% with the same initial capital. Does that mean that Mr. Wrigley has a better company?

Look now at the EPS line, which is essentially the PAT divided by the number of shares issued (Wrigleys issued 80 and LeverMax only 20 both for $1 per share). The EPS figure for LeverMax nearly triple what Wrigley's has managed! The PE ratio for Wrigley's is 5x while LeverMax is only 1.7x.

First we thought Wrigley's had a better company earning 35% more on the same capital, but we now know that LeverMax earned triple in a per share basis! If the businesses are exactly the same, should they trade on a similar PE and if they should, does that mean that LeverMax share prices should triple to $3?

Obviously LeverMax shouldn't warrant a 300% increase in share price as if it did, Mr. Wrigley could simply say, "Okay, I'll borrow $60 from th bank, repurchase 60 shares and my company would be identical to LeverMax leading to a quick 300% for me!"

When leverage is a problem, it is better to move onto enterprise value based calculation methods. The enterprise is calculated as Equity + Debt - Cash. Of course you can get a little tropical by adding in pensions, minorities, prepayments etc etc but lets keep it simple.

As you can see by the above, both Wrigleys and Levermax have converted all their cash into new stock, hence inventory.

The enterprise Value thefore stands at equity + debt and so after the first year, the Wrigley's enterprise value is $116.10 while LeverMax is only $111.9 (prior to operation, both companies had the same EV). Looking at their trailing EV/EBIT, you will notice that the companies are valued at rather similar levels (Wrigley's at 4.64x and LeverMax at 4.47x the only difference being the extra few dollars Mr Wrigley saved by having less interest to pay).

The morale of the story here is that you should never take PE as an unstainable measure of value. It definitely has its uses but it must be applied only when leverage is comparable.

Moving back to Mr. Wrigley and Levermax, we could ask the question "What is the acceptable level of debt". If both companies paid 50% of Profit as a dividend, Wrigley's would have $8 to pay amongst 80 shares (10c per share) and LeverMax would have $6 to pay among 20 shares (30c per share) despite the fact the Wrigley's earned more. Of course you would prefer to hold LeverMax shares as they have a more optimal capital structure in the chewing gum market (which is a pretty safe and predictable one) but the cost of having debt is the increased operational leverage in the business.

Lets assume, the PowerMint company comes up with the year round breath mint (chew once for fresh breath all year). As a result, demand for chewing gum drops and our companies have to sell their gum for 42c per stick as opposed to 50c (16% drop)

While Mr.Wrigley will continue being profitable, LeverMax becomes loss making. In fact, the true cash performance is even worse. In the above table, LeverMax are gaining $0.9 in tax credits (depends on country to country) which can only be used once profitable so PAT would remain at $3 or minus 15 cents per share.

While leverage allowed LeverMax to pay their shareholders off in the good times, it has effectively bankrupted them in the bad.

The morale of the story? Make sure you rely on a variety of indicators that allow you to paint a wholly unbiased picture of valuation (all indicators can be manipulated in isolation) as opposed to latching onto the ratio that corroborates your opinion.