P/E multiple explanation?

Discussion in 'Economics' started by HezBallah, Oct 27, 2012.

  1. Wiki quotes:

    "P/E ratios are highly dependent on capital structure. Leverage (i.e. debt taken on by the company) affects both earnings and share price in a variety of ways, including the leveraging of earnings growth rates, tax effects and impacts on the risk of bankruptcy, and can sometimes dramatically affect the company's results. For example, for two companies with identical operations and taxation regime, and trading at typical P/E ratios, the company with a moderate amount of debt will commonly have a lower P/E than the one with no debt, despite having a slightly higher risk profile, slightly more volatile earnings and (if earnings are increasing) a slightly higher earnings growth rate.
    At higher levels of leverage (where the risk of bankruptcy forces up debt costs) or if profits decline substantially (driving up the P/E ratio) the indebted firm will have a higher P/E ratio than an unleveraged firm.
    To try to eliminate these leverage effects and better compare the values of the underlying operating assets, it is often preferable to use multiples based on the enterprise value of a company, such as EV/EBITDA, EV/EBIT or EV/NOPAT."

    Shouldn't the debted firm have a lower p/e ratio? A company with heavy debt will trade at a lower price, lowering the p/e ratio no?
  2. andread


    lower earnings because of the debt?
  3. Wiki is done by people with a broad range of concerns.

    P/E ratios are dynamic and E leads P. Or ir could be said P lags E.

    With that in mind, turn your thoughts to how ratios, rates and fractions work.

    Debt requires servicing and this could affect earnings negatively..

    On the otherhand, taking on debt could make the performance process more effective and more efficient.

    Both of the above are rates.

    To use information to make money, at some point you have to not use Wikipedia any longer.

    Then, at that time, you will be able to compose questions that are meaningful and focused on using information to make money.

    Here is an example.

    I did a TFSE where I contributed 5 corporations to a parent. I became CEO of the parent.

    As Quarters past, the E of the parent was enhanced. The P/E when from 15 to 60. That is the E was increasing and this caused the P to follow at four times the rate (A fraction as well) of E.

    From this example you can see how I leveraged my investments and could made more money (more borrowing power) using parent stock as collateral. This meant I could incubate more corporations around other cool ideas.

    Being an "incubator" is very environmentally significant to "chicks" who are naturally high maintenance.

    A not too incidental value was that I was then publically traded instead of being in the boonies with 5 privately held corporations.

    My native language is Mandarin so this English may not be too clear to you or the sponsors of ET (who, apparently, need road maps).
  4. Don't companies get a tax shield by having more debt. In the UK they can write the debt interest payments off as an expense. They can't do that with dividend payments. Making it more cost efficient to hold debt.
  5. andread


    but, even if written off, an expense is an expense. It does impact your earnings. If your revenue is 200, 50% tax rate, you pay 100. If you pay 100 for a debt you can deduct it, but you still make 50.
    I'm a poor accountant, but I should be able to get this right :)
  6. No in the UK things are different there is an acknowledged advantage for debt capital.

    Interest Tax Shield
    A reduction in tax liability coming from the ability to deduct interest payments from one's taxable income. For example, a mortgage provides an interest tax shield for a property buyer because interest on mortgages is generally deductible. An interest tax shield may encourage a company to finance a project through debt because dividends paid on stock issues are never deductible.


    Dividends paid on stock are not deductible.
  7. andread


    I might get it wrong, but it looks the same to me. You deduct your interest payments, so you don't pay taxes on them. But you still have those payments, and because of the payments your earnings are smaller, even without paying taxes.
  8. Ed Breen

    Ed Breen

    It depends on what you do (did) with the capital what you are paying the debt service on. If you borrow capital and invest it in assets that produce more future income than the cost of capital then you are increasing real value. If you don't, then you are decreasing real value.

    Another way to look at the issue is in terms of future earnings volatility. If you have a high confidence of stable future earnings from existing assets, you can decide to leverage those assets and distribute the capital borrowed to shareholders through share buy backs. When you do this, you can as morganist advises, deduct the cost of the leverage, distribute the value of the borrowed capital to the shareholders through increased share price (due to buy backs) and still reduce the corporate tax burden (as future income has been diverted into present share value). On the other hand, if you future earnings are not as safe as you thought you can destroy shareholder value in a recession.