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Varchild2008 (83.60)

Debt Levels impact P/E Valuations

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January 12, 2011 – Comments (3) | RELATED TICKERS: DPS , NIVS

My Hypothesis is that Debt Levels exceeding Cash usually result in ridiculously cheap P/E, as compared to the historic P/E that company carries when Cash exceeds Debt..... Or against Industry Peer's P/E.

That's my hypothesis and I am being labeled as spouting off pure nonsense..... Really?

" Varchild - I do not care what ScottTrade says about NIVS or any other stock. I'm saying that your statement:  "Whenever Debt Exceeds Cash, the P/E is ridiculously low." is not true. "

Well, one would have to go through 1,000 stocks at random and check their Debt to Cash ratios and their P/E against Peer/Industry P/Es to prove or disprove this.

Labeling my statement as pure nonsense is completely wrong.

(F) Ford Motor Company  and (NIV) carry ridiculously cheap P/E ratios while their Debt exceeds cash levels.

And it does make sense as a Debt level that exceeds Cash usually signals the business is struggling in some way... Either spending too much money on administrative expenses, or other expenditures (hurting their profit/gross margins), or their sales took a dive.

(DPS) Dr. Pepper Snapple Group is also another excellent example proving my point.

When that Stock debuted on the stock market it carried a share price of around $25.50.  Today it is around $36 per share.

As the company's sales helped lower the company's debt, the P/E multiple increased dramatically for Dr. Pepper Snapple Group.

Investors panicked on (DPS) in the beginning punishing the stock to  March 2009 low price of less than $12.00 on intraday basis.

How in the heck is DEBT not a factor to how Wall Street Investors view a Stock's P/E multiple valuation?   The big money players are the ones that can Walk a stock up... They are the ones that can push a stock to a higher P/E.  They are also the ones that tend to abandon/avoid a stock that has too much debt.

3 Comments – Post Your Own

#1) On January 13, 2011 at 12:16 AM, tekennedy (70.37) wrote:

Yeah, debt is very important in valuing a company.  A nice easy way to look at it is looking at Enterprise Value (EV).  This is the price which the company would be acquired at (less the premium) and is equal to Market Cap + Debt - Cash.  Often companies in the same sector with similar properties and business prospects will have a similar EV/EBITDA.  Its simple really: if 2 companies are identical except 1 has $1 billion in debt and the other doesn't, then the company without the debt can immediately issue $1 billion in debt and return it to shareholders.  This theoretical company should be worth $1 billion more.

Also the presence of debt greater than cash says nothing about whether or not a business is struggling.  There are countless examples of companies which have debt and are in great shape.  Issuing debt can be a good decision for shareholders if the company can reasonably cover interest etc.and the company has good use for the cash.

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#2) On January 13, 2011 at 2:32 AM, checklist34 (99.69) wrote:

caps.fool.com/Blogs/when-debt-can-be-good-in/250940

my blog from august of 2009

I think this is a fundamental mispricing of stocks that, provided the debt can be managed over time,...

the cheaper p/e can get even cheaper as the debt is paid down as interest stops eating away at earnings.  creating a bit of leverage in addition to growth...

i also think the market overpays for cash on the balance sheet

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#3) On January 13, 2011 at 10:35 PM, tekennedy (70.37) wrote:

@checklist- good link.  You were 100% right about that time period and still could be right in a number of situation but I'd be willing to say that a high debt level magnifies undervaluations. 

If you have 2 companies which normally trade at an EV/EBITDA of 8.  Company A has 1/2 its EV as debt, Company B is 100% equity.  If you get a 20% discount on EV (EV/EBITDA is 6.4) for each you get a 40% discount for share price on company A, and a 20% discount for company B. 

I wouldn't say the market overpays for cash.  There may be instances where they do but there will always be counterexamples such as Cisco or NVR. 

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