Let’s start with the most common response. When a company takes on more debt, it incurs additional interest expense so it has lower earnings and therefore the PE multiple increases. That’s how most candidates answer this question and unfortunately that’s incorrect.
It’s an arithmetic answer that fails to account for the equivalent change in Stock Price. Without the factors listed below, the Enterprise Value of the company stays the same, so by taking on additional debt, Equity Value actually declines. Equity Value = Stock Price (x) Shares Outstanding. And since Shares Outstanding doesn’t change when a company increases debt, the Stock Prices also goes down, canceling out the decline in earnings.
The correct answer here is that the effect on PE is indeterminate because there are multiple levers pulling the multiple in different directions as a company takes on debt. The interviewer is looking for you to identify these drivers of valuation multiples.
So let’s jump in.
Factors Driving PE Multiple Up
WACC Curve The Enterprise Value of a company is the present value of all the future unlevered free cash flow it will generate discounted back using WACC. While future unlevered free cash flow isn’t affected by taking on additional debt, WACC is. The relationship between WACC and the debt amount is a U-Curve (Exhibit 1). In the beginning, because cost of debt is so much lower than cost of equity, increasing debt “averages down” the company’s WACC. When WACC decreases, the company’s future cash flow are worth more and so its Enterprise Value increases. The increase in Enterprise Value is translated into an increase in Equity Value and this incremental increase in Equity Value leads to a higher PE multiple.
Accelerated Growth In most instances, growth is the single biggest driver of valuation multiples. Investors are willing to pay a higher PE multiple for a higher growth business. By levering up with additional debt, companies can financially engineer an accelerated earnings growth. Take a look at Exhibit 2. By levering up with debt, the company will grow at a faster rate. So with higher growth, investors are willing to pay a higher PE multiple
Factors Driving PE Multiple Down
WACC Curve While the WACC curve can pull the PE multiple up, it can also push it down depending on how far the company is along the curve. As mentioned above, the relationship between WACC and debt amount is a U-Curve. While increasing debt in the beginning “averages down” the company’s WACC, taking on too much debt will cause the cost of debt and equity beta to increase dramatically, reflecting the increased financial risk of the business. At that point, WACC starts to rise and that decreases Enterprise Value. The decrease in Enterprise Value translates to a decrease in Equity Value and this incremental decrease in Equity Value leads to a lower PE multiple.
Restrictive Covenants Debt issuances can come with restrictive covenants that limit the company’s ability to reinvest into the business through CapEx or M&A With limited reinvestments in the business, the company might not be able to grow as fast and equity investors will pay a lower multiple for the business. Creditors want these covenants because they ensure that the company will have enough cash flow to repay them. However, these restrictions are often at the expense of equity holders.
So there you have it. Two levers pulling P/E up and two levers pulling it down.
Thanks for reading! Hope this enhances you understanding of valuation multiples. We’ll post more as part of our Technical Series and if there’re any specific questions you’d like us to cover, email us at email@example.com.
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