Does it matter to a company how it gets capital to increase profit? Does it matter whether it has to pay interest or a fixed dividend as would be the case with preferred shares? Not really.
The difference is more important to the lenders and preferred share owners. Whether the company pays interest on money invested out of operating profit (profit before interest, taxes, depreciation and amortization = EBITDA) or out of net income (profit after debt financing, taxes, depreciation and amortization) does not really matter does it?
A lender though gets paid interest before the common and preferred share owners are paid. In case of dissolution of the corporation, first the lenders (in order of seniority), then the preferred share owners and finally the share owners are paid out from the sales proceeds of a company’s assets. Thus lenders have a better chance to recoup their investment capital than preferred share owners. Last in line are the shareholders; but for taking those risks the shareholder’s upside is greater than that of the other capital providers; that of the preferred share holder is somewhat less and typically fixed; and the lenders get an even lower fixed return.All three groups are capital providers and in today’s corporate world it is management and the board of directors that steer and control the plublic company. In theory the shareowners control the company, but what is ownership without real control? Only over the last number of years with the rise in shareholder activism, shareholders could, under special conditions, take some decisive action as shown for example at CP Rail. However, this is more the exception than the rule.
Still, since shareholders own the corporate earnings (after preferred share dividends), the shareholder should understand the corporation’s potential to make money. How else is the shareholder to choose which company to own?
So let’s look at a company’s capital structure. The question to ask is: “If I as an owner could borrow money at 3% and earn with that money 9%, why would I not use ‘leverage’?” To answer that, we have to look again at the example company’s income statement and balance sheet. First shown below is the income statement assuming 50% debt and 50% shareholder equity:
Figure 1 Income statement of 50% levered company
Shoot! It looks nearly the same as that of a company without leverage. Operating Profit, just like with the APOD is not affected by financing costs! But we do, in addition to taxes, now also have to pay the interest before counting the chickens, eh… Net Income. Oh, this is cute! See, we FIRST deduct the interest from our Operating Profit and then the company pays tax over the remainder. Instead of paying $2 million in taxes the levered corporation pays ‘only’ $1.7 million. The government pays part of the interest!
So in fact we don’t pay 3% interest but 3% minus 0.3% = 2.7% interest to earn 9% income. And there is more! At first sight, our net income is down from $18 million to $15.3 million to be divided amongst 10 million shares or down from $1.80 for the debt free corporation to $1.53 per share for the levered corp. Sounds not good unless you know how much was invested per share, i.e. the book value per share. For that we need the balance sheet.
Figure 2. Balance Sheet of company with 50% debt
This balance sheet is different from the company without debt (compare with Figure 3). At the start of the year total assets were $200 million for both companies. However, the debt free company had $200 million shareholder equity or a book value of $20 per share while the levered company has only $100 million shareholder equity (the rest is debt) or a book value of only $10 per share. So, the investors in the debt free corporation paid $20 per share to earn $1.86 or a 9% return on equity compared to paying $10 per share to earn $1.53 or a 15.3% return on equity in the levered corporation. Who did better? Right, the investors who paid $10.00.
Figure 3. Balance sheet of corporation without debt.
OMG accounting is so difficult! One needs at least to know some high school math to understand this. J BUT, there always is a ‘but’! And there is where the risk lies!Well there are many buts. Let’s start with the most obvious ones. Say inflation picks up its ugly head and thus interest rates rise. Say inflation rises from 2 to 5%. So production costs went up by 5%. But also a new competitor entered the market and this prevents our levered company from increasing prices. Oh, and then interest rates have to increase as well from 3% to 6%. How does our profit picture look now?
Well the Profit Margin dropped in both companies (debt free and 50% levered) from 10% to 4.8%. Painful! Net income dropped from $18 million to $9 million in the debt free company and from $15.3 to $3.6 million in the levered company. Percentage wise that is a net income reduction of 50% and 76% respectively! If both companies were trading first at a P/E of 12, now investors would likely not willing to pay more than a P/E of 9 or maybe even less. The stock price in the debt free company would then be: 9 x 0.9 or $8.10 down from $21.60 and that of the levered company would be 9 x 0.36 = $3.24 down from $18.36. Those are price drops of 63% for the debt free and 82% for the levered company.
So you can see that with debt, the investment risk has dramatically risen. You, the investor, do not control the debt level of your company. It is management that does. This is a significant difference with real estate where you set your debt level. The only control the investor has is to investigate the company’s debt level prior to purchasing its stock. There are two other very important points to make.
As a founding investor, the money that you pay for a share goes entirely to share equity. Thus you paid $20 for $20 book value in the debt free company and $10.00 per share for $10 net assets in the levered company. But the stock market investor pays for earnings, i.e. the share price is set by the price/earnings multiple (the P/E ratio). Now if you were one of the lucky investors who put up the founding capital in the debt free corporation rather than that you bought the stock at the Initial Public Offering or in the stock market, what would you do when you went public and sold part or all of your company to stock market investors?
Well first you would sell the company at a time of maximum profit margins in order to get the highest price, i.e. the highest P/E ratio. Say that your ‘growth company’ at the time of IPO sells for a P/E of 13 then what would you do right before the offering? Right, get leverage and not by a conservative amount; but as much as you likely could get away with. After all, it is the new investors who will have to pay the interest! So rather than selling your company at 13x 1.86 or $24.18 for a measly profit of $4.18 you would take out 50% of the equity or even more and replace it with a loan. Now you have recovered $10.00 per share and your selling the company for 13 x $1.53 (net income per share after interest) = $19.89 and you made at total profit of $29.89 - $20 = $9.89 per share (more than double the profit without the debt). Your return would be not $4.18/20 = 21% (in one year) but $9.90/$20 = 50%. Wow!!Who pays for that? The IPO investor and on top of that the IPO investor takes on the liability to pay back the loan! Now who is getting here the short end of the stick? Add to that the commissions for the investment bankers and lawyers who administered the deal and you can easily understand why you don’t want to buy an IPO! Ever! Never has the term: ‘Caveat emptor’ or ‘Buyer beware’ been so applicable!
There is though a golden side to this story. North American Blue Chips are right now flush with cash! Do I have to say more? See you at the next post?