Equity Versus Debt: A Showdown

The equity multiplier is a simple formula: assets divided by equity. It’s frequently used as a measure of financial leverage, since assets minus equity equals liabilities. Everyone seems to agree that a lower equity multiplier is better. Investopedia:

It is better to have a low equity multiplier, because a company uses less debt to finance its assets.

The higher a company’s equity multiplier, the higher its debt ratio (liabilities to assets), since the debt ratio is one minus the inverse of the equity multiplier. So it follows that a low debt ratio is also a good thing. As YCharts puts it:

Companies in signs of financial distress will often also have high L/A [liabilities to assets] ratios. A company facing declining revenues and poor long-term prospects of growth will be impacted on retained equity. Companies with low L/A ratios indicate a company with little to no liabilities. With some notable exceptions, this is normally a good sign of financial health for the company.

Every single accounting website I’ve seen says the same thing: lower equity multipliers and lower debt ratios are better than higher ones.

The purpose of this article is to challenge this conventional wisdom and to argue the exact opposite: a high equity multiplier—and therefore a high debt ratio—is actually a good thing.

1. The DuPont Identity

The DuPont Identity is a simple formula. You can break down return on equity (net income divided by shareholder’s equity) into three components: net profit margin (net income divided by net sales), asset turnover (net sales divided by average assets), and equity multiplier (average assets divided by average equity).

So let’s take two companies with similar asset turnover and profit margin. Which one will have the higher return on equity? The one with the higher equity multiplier.

I’ll make this concrete. Let’s look at two companies, Kubota (KUBTY) and W. R. Grace (GRA). Both of them have a 58% asset turnover and a net profit margin between 8.5% and 9%. Kubota has an ROE of 11% while Grace has an ROE of 34%. Huge difference, right? That’s because Grace has an equity multipier of 7.5 while Kubota’s equity multiplier is only 2.1.

Now what does Grace’s huge equity multiplier actually mean, though? It means that it has $2.94 billion dollars in assets and $2.55 billion in liabilities. Compare that to Kubota, with $23.3 billion in assets and $12.1 billion in liabilities. In a word, Grace is far more leveraged than Kubota.

Does that mean that Grace is a worse investment, though? Not at all. (Well, I think it is, but not for that reason.) Both companies have about the same debt-to-EBITDA ratio (3.9 for Grace, 3.8 for Kubota). So neither of them are facing a huge risk there.

My point is that when we look at leverage, we have to also look at the other side of the coin: equity. The more a company is leveraged, the less equity it has. Why? Equity is simply total assets minus total liabilities. And according to the Dupont Identity, the lower the equity, the better the investment.

2. The Cost of Capital

One can reach the same conclusion by looking at the cost of capital. The cost of equity is always higher than the cost of debt, and usually significantly so—double or triple in some cases. Debt may be riskier, but it’s a far cheaper method of funding operations.

In case you’re unfamiliar with classical accounting and the weighted average cost of capital, here’s why the cost of equity is always higher than the cost of debt. In what case would you, as an investor, expect a higher return on a bond (debt) than on a stock in the same company? If your answer is “never,” then you’ve got it down and you can skip the rest of this paragraph. But if you have doubts, think of it this way. If the company goes belly up and you’re holding stock in it, that stock is worthless, but if you’re holding debt, you get paid first. Now if people were to expect the same return on a bond as on a share, then nobody would ever buy stocks. The only reason that stocks are ever bought is that they promise higher returns than bonds.

We’ll come back to this in a minute. First, I want to propose a practical experiment. Let’s say you invested in the top 10%, according to their equity multiplier, of stocks in the Russell 3000 with a $100 million market cap or more, a price of $1.00 or more, excluding financials, real estate, and utilities, with a quarterly rebalance since the beginning of 1999. (Because equity can be negative, I’m using as my formula one minus the ratio of total equity to total assets instead of simply total assets divided by total equity.) These are companies with loads of debt and other liabilities and relatively little equity, companies like Home Depot (HD), Boeing (BA), UPS (UPS), ADP (ADP), and Kimberly-Clark (KMB). (My evaluation system, which I outlined in an earlier article, currently gives them scores of 74, 95, 64, 81, and 88 out of 100.) Using Portfolio123, I can simulate this screen. You would have realized a tidy 10.8% annual return.

If, on the other hand, you’d invested in the bottom 10%, the companies with the lowest debt ratio, the lowest equity multiplier, the fewest total liabilities—companies like Alphabet (GOOGL), Facebook (FB), Cognizant Technology (CTSH), Liberty Broadband (LBRDK), and Snap (SNAP) (scores: 87, 64, 94, 2, and 7)—you would have made a piddly 1.9% annual return.

Now I’m going to be even more extreme. I’m going to create two stock screens. One is of companies with negative equity, companies whose liabilities are greater than their assets, like Philip Morris (PM), McDonald’s (MCD), Lockheed Martin (LMT), Colgate-Palmolive (CL), and HP (HPQ) (scores: 86, 84, 61, 93, and 98). The other is of companies with no debt at all, like Intuitive Surgical (ISRG), Monster (MNST), Align Technology (ALGN), Skyworks Solutions (SWKS), and Ulta Beauty (ULTA) (scores: 60, 42, 31, 85, and 37). I’ll use the same modified Russell 3000 universe, but this time I’ll rebalance yearly. Which do you think will outperform?

Well, the debt-free companies will give you an annualized return of 9.83%, for a total return of 498%. That’s not bad at all. (The reason that this is so much better than the companies with extremely high equity multiples is that most of the high-equity companies not only have little to no debt but have very low other liabilities; the debt-free companies, on the other hand, can have large non-debt liabilities, which are very valuable for a company’s prospects. I’ve written a bit about non-debt liabilities here.)

But the negative equity companies will give you an annualized return of 13.33%, for a total return of 989%. You would have earned about twice as much buying these companies as you would have buying the debt-free ones.

So here’s the paradox. How is it that companies with very little equity and, therefore, lots of leverage, outperform companies with no debt at all?

One answer lies in the cost of capital. There are basically three ways a company can fund its continuing operations and its future growth. It can use cash, which has no cost whatsoever; it can use debt, for which it pays interest; or it can sell shares, which costs a great deal of money.

First, there’s the underwriter’s fee, which can range from 5% to 10% of the proceeds—significantly higher than interest on a loan. There are external auditors’ fees and payments to lawyers. There are all the costs attendant to marketing and publicizing the offer. And then there are onerous auditing costs related to satisfying regulations concerning public companies.

But those costs aren’t even part of the cost of equity, which is, theoretically, simply the return the company is supposed to give its investors to pay them for the risk they take by buying shares. This cost is usually fulfilled through share buybacks and dividend payments.

I’ve run some more numbers using Portfolio123. Last year, the companies in the S&P 500, excluding financial and real estate firms because debt means something totally different for them, spent an average of $2.027 billion on share repurchases and dividends, and an average of $406 million on interest payments. OK, we are in a very low-interest-rate environment right now, so let’s look at the same numbers in 2000, when interest rates were far higher than they are now. The discrepancy wasn’t as large, but it’s still significant: these firms spent an average of $476 million on share repurchases and dividends, and only $214 million on interest. To put these figures in perspective, the current average equity of these companies ($12.1 billion) is almost the same as its debt ($11.6 billion), and the same was true back in 2000 ($3.2 billion to $3.3 billion). Clearly the cost of equity is far higher.

Now I’m not saying that companies with negative equity never pay dividends or buy back shares—of course they do, and in spades. But their huge debt load, which is comparatively cheap, gives them a much greater ability to grow. The median EPS increase over the last twelve months of stocks in the modified Russell 3000 universe specified above that had negative equity a year ago is 20.86%; the median EPS increase of those that were debt-free is only 3.38%. Now that is quite a difference indeed.

3. The Risks of Debt and Equity

Now the other major difference between equity and debt financing is risk. Debt is risky—too much debt, and your company will go bankrupt. And according to classical accounting/portfolio theory, equity is basically risk-free—no matter how much equity you issue, you’re not going to go bankrupt by issuing more. So the higher costs of equity have been traditionally balanced by its lower risk, and the lower cost of debt is balanced by its higher risk. That’s the foundation of the Modigliani-Miller theorem, which maintains that capital structure is irrelevant.

But there are two problems with this theory. The first, which has been long recognized and is related only to cost, not to risk, is that the Modigliani-Miller theorem doesn’t take into account the tax benefits of debt. Interest payments are fully deductible; dividends and stock buybacks are not. Therefore, even when taking risk into account, debt financing is better than equity financing.

The second problem is that the theorem doesn’t take into account that equity, especially for small firms, now carries great risk. There’s a terrific interview with Marc Andreessen here which explains exactly how risky it is for a small company to go public nowadays.

But let’s just go with Modigliani-Miller for a moment and assume that we want to mitigate the risk of debt. The best way to do so is to use the debt-to-EBITDA ratio, since this is the ratio most commonly used by credit rating agencies when they’re assessing a company’s solvency. Let’s say you had invested in the non-financial, non-real estate Russell 3000 stocks with a debt-to-EBITDA ratio greater than 8, rebalancing quarterly since 1999. These are companies with lots of debt and low earnings, companies like Tesla (TSLA), Ford (F), ServiceNow (NOW), Alliance Data Systems (ADS), and Cheniere Energy (LNG) (scores: 1, 96, 40, 77, and 1). You would have earned an annualized return of only 2.4%, compared to SPY’s return of 6.21%. And that’s not taking into account all the companies with negative EBITDA—companies like Workday (WDAY), Autodesk (ADSK), Square (SQ), Biomarin (BMRN), and Hess (HES) (scores: 41, 48, 15, 55, and 7)—whose annualized return would have been –2.43%.

I’m going to do another experiment that takes this into account. I’m going to create a system that ranks stocks based on two factors: the equity multiplier (I’ll reverse this and use equity to assets, with lower numbers better, since I want to reward companies with negative equity) and the debt-to-EBITDA ratio (to include negative EBITDA companies and zero-debt companies, I’ll reverse the ratio with a minimum denominator of $1 million and give higher numbers better ranks). This will basically reward companies with very little equity and a decent ability to pay their debts. Just to prove my point, I’m going to weight these two rankings 3-to-1 in favor of the equity multiplier. Now I’m going to test the performance of this system on two universes: the S&P 500 and the Russell 3000 (both excluding financial and real estate firms) based on a monthly rebalance since January 1999. Here’s the result, with the numbers on the left representing annualized percentage returns for each decile:

As you can see, by diminishing the risk factor of debt just slightly, we end up with a very nice ranking system that rewards high-equity-multiplier companies. Just to reiterate, this ranking system would have been exactly the same if it had been based on the debt ratio rather than the equity multiplier. Because of the high cost of equity, high-debt companies outperform as long as their debt doesn’t exceed their earnings by too much.

4. Book Value

I’ve been spending this whole article talking about equity without bringing up a very important identity: equity (assets minus liabilities) = book value. They are exactly the same.

As I’ve shown, as long as you exclude companies with unsustainable debt levels as measured by debt-to-EBITDA, it’s better to invest in companies with a very low book value than companies with a very high book value, at least if you compare that book value to total assets. But if you use the price-to-book ratio, you’re going to be favoring companies with a high book value (relative to their market cap), and therefore a low equity multiplier. And that doesn’t really work very well.

Let’s say you start with the S&P 1500 and exclude financials and real estate companies. Now let’s say you invest only in stocks with a price-to-book ratio of less than 1, rebalancing quarterly, with a 0.5% slippage each rebalancing—stocks like Allergan (AGN), National Oilwell Varco (NOV), Baker Hughes (BHGE), CenturyLink (CTL), and News Corp (NWSA) (scores: 52, 20, 14, 28, and 95). Your total return since 1999 would be 109%, which is half as much as investing in SPY (216%). If instead you had invested only in stocks with a price-to-book ratio greater than 5—companies that today would include Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Alibaba (BABA), and Johnson and Johnson (JNJ) (scores: 73, 88, 53, 39, and 84)—you would have made 408%. That’s quite a difference.

(The reason I excluded financial and real estate companies from this analysis is that price to tangible book value is a good criteria for valuing companies in the financial sector and price to net asset value—which is often quite close to book value—is a good criteria for those in the real estate sector. Outside those two sectors, however, I think price to book value is worthless.)

What makes this truly pernicious is that a large number of institutions have classified stocks into “growth” and “value” classes, and define “value” as stocks with low price-to-book ratios. I have not come across a more useless definition of value, nor one more contrary to the way value investing really should work. Simply put, the relationship of the market value and the book value of equity tells you almost nothing of any use because it ignores almost everything of importance about the company and treats the entirety of a company’s debt as a problem rather than a possible solution.

One of the great things about enterprise-value-based valuation ratios (EV to EBITDA, unlevered free cash flow to EV, EV to gross profit, etc.) is that the enterprise value of a company is a kind of shorthand for its cost of capital. Remember that EV is market cap plus debt minus cash. Market cap is the market value of equity, and has the highest cost of capital, so it carries a lot of weight in determining EV. Debt in this equation is valued far lower than its market value, since the equation doesn’t include interest payments; this is the right approach since debt has a lower cost of capital. Cash has no cost whatsoever, and can be used to either buy back shares or pay down debt; its weight in EV is negative, which reflects how wonderful it is. In other words, a company’s cost of capital is going to be roughly proportional to its enterprise value. So if you’re worried about the cost of capital, it makes a lot more sense to use enterprise value-based ratios than book value-based ratios when evaluating your stock picks.

So I propose that instead of looking at price to book value as your default balance-sheet ratio to estimate the worth of a company, look at enterprise value to total assets. This ratio is seldom used, but it works very nicely. Here’s how it has worked if you rebalanced stocks in the Russell 3000 (excluding financials, real estate, and stocks under $1.00) monthly since 1999:

5. The Biggest Debt-Related Mistakes Investors Make

In sum, here are the big mistakes that investors commonly make when it comes to looking at a company’s debt (or equity multiplier):

• They determine whether a company is overleveraged by looking at its debt ratio or its equity multiplier. They should instead look at its debt-to-EBITDA ratio.
• They focus only on whether a company is reducing or increasing its debt and not on whether it’s increasing or reducing its equity. The cost of equity is always greater than the cost of debt.
• They use the price-to-book ratio as a shortcut for value instead of looking at a range of other measures.

6. The Paradox of Debt and Equity

Why do we investors make these mistakes? It’s because when we think about debt, we think about household debt, personal debt, credit card debt, the national debt, debtor’s prisons in Dickens novels, student loan debt, collateralized debt obligations, and so on and on. Debt is a bad word. And when we think about equity, we think about the equity we have in our houses, and about stocks, and how they go up and up and yield great returns, and how much fun it is to pick them, and how much more rewarding it’s been investing in equity ETFs than fixed-income ETFs, and so on and on. Equity is a nice word.

But none of these concepts apply to running a successful public company. A public company is entirely different from a person, or a household, or a government. It has equity costs, and we don’t.

So imagine that you're a public company.

You—yes, you, with your credit-card debt, your monthly mortgage payments, and your outstanding student loan—sold, a few years ago, a large percentage of your future earnings, in perpetuity, to other people so that you could afford what you needed at that time. And those people have the power to decide what you do with the rest of your life so that their income from that percentage will be maximized.

There’s really only one parallel to this in contemporary life: if you’re a prostitute, you pay your pimp a percentage of your earnings, and he gets to decide what you wear and how many clients you service and where you get them from. A bygone parallel is the case of a slave who gets to keep a small portion of his or her earnings, which was actually quite common in the eighteenth century. At any rate, in this scenario, someone, or a group of people, basically owns you.

Now if you could save enough money, which would you do first—buy back your future earnings and your decision-making power by paying off the owners, essentially engaging in a massive share buyback? Or pay down your debts? And if you could buy back your future earnings now by maxing out your credit card, wouldn’t you do so, provided your earnings were sufficient to eventually pay it off?

That’s how we should think of equity. Equity, for public companies, is prostitution (or slavery—take your pick). Debt is freedom.

OK, that’s a little extreme. But I wanted to make a point. Don’t put down companies with large debts but decent earnings. Don’t imagine that book value is a good comparison to a stock’s price. Don’t scoff at share buybacks, which reduce equity. Don’t imagine that paying down debt will increase growth. Instead, take a long, hard look at what its debt and equity really mean for a company and its future, and invest accordingly.

7. Postscript: The Future of Equity

I’m no expert in macroeconomics, and I normally avoid writing about it. But I suspect that we’re in a moment when the cost of equity, historically speaking, is at a near-record high and the cost of debt at a near-record low. Interest rates on corporate bonds are so low at this point that investors are putting a larger percentage of their money in stocks than at any time since the dot-com boom. (See this chart, which tracks the allocation to equities among overall investments.) This drives up stock prices, which contributes to the high cost of equity. Then this cost, along with onerous regulations and unlimited short selling, ensures that IPOs, especially of small companies, are drying up altogether (here's an article about that). Meanwhile, also because of the high cost of equity, stock buybacks are at a historic high. This in turn creates a scarcity of investable stocks, which drives up prices even further. It’s a vicious cycle.

This cycle can be broken, however, and surely will be at some point. Regulations on public corporations can be relaxed to encourage private firms to go public. IPO costs can fall because of decreased demand. Interest rates can rise, increasing the cost of debt, moving investment money from stocks to bonds, and lowering the relative cost of equity. Stocks can enter a bear market, prompting equity costs to fall. Any one of these things can precipitate a change, and all four seem somewhat likely to me.

While equity will always be more expensive than debt, the disparity doesn’t have to be as huge as it is right now. But while it is huge—before all these things happen—it pays for individual stock-pickers like you and me to pay far less attention to company debt than most people think we should.

CAGR since 1/1/15: 48%

My top ten holdings right now: HDNG, BBRG, CERC, CTG, NWY, WSTL, UWN, HURC, GSL, BCML.

Comments

[Anlam Kuyusu]

Great post, Yuval. You are convincing me to change my mind about debt.

I also want to point out this recent MF podcast that also focused on debt in part.

http://mebfaber.com/2018/01/17/episode-90-dan-rasmussen-crown-jewel-alternative-universe-private-equity/

[Yuval Taylor]

Anlam - Thanks for the compliment, and thanks for the link. That's a fantastic interview--I really learned a lot.