Meme of the week: More debt, less equity

Floyd Norris and Dean Baker and Wcw are all on the case of the good old-fashioned debt arbitrage. As Wcw puts it, either “bonds are overvalued, equities undervalued, or both”.

Or, of course, you have to remember the bearish position: equities are overvalued, but bonds are even more overvalued. Which is not very helpful if you’re looking for somewhere to invest, but at least makes you feel a little bit better if you don’t have any money to invest in the first place.

As a public service, let me explain what all these people are talking about, using a hypothetical company which makes $1 billion of profits every year, which amounts to $1 per share. It pays those profits out in dividends, and the stock price is 15 times earnings, or $15 per share.

Now let’s say the company borrows $10.2 billion, at an interest rate of 5% per year, and uses it to buy back its stock at say $17 per share. Now there were 1 billion shares outstanding originally, but the company has bought back 60% of them, which means that the total amount of shares outstanding has dropped to 400 million. It’s still making $1 billion per year, but now it needs to repay $510 million per year in interest, so total profits have now dropped to a mere $490 million. It pays those profits out in dividends, and — presto — the dividend has actually risen, to $1.22 per share! That’s 20% earnings growth, that is, so the stock price is no longer 15 or even 17 times earnings, but rather 20 times earnings. Which puts it at $24.50.

In other words, it’s quite easy, if debt is cheap enough, to raise your earnings per share without raising your total earnings, just by borrowing money. Note that in my example, if the company paid 6% a year on its debt rather than 5% per year, none of the leveraging would work. But at 5%, it can boost the share price by more than 60%.

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2 Responses to Meme of the week: More debt, less equity

  1. Robby says:

    Why would the p/e ratio rise when the earnings per share is increased in this manner? Shouldn’t the p/e ratio fall now that the firm is riskier since it has taken on debt? Thanks.

  2. Felix says:

    Fabulous question. And I daresay you’re right in an ideal world. But in this non-ideal world, when stock-market investors see EPS growth, they tend to bid up the stock, and the p/e ratio rises.

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