February 6, 2003;
The Kiss of Debt
There is an article in the November/December 2002 edition of Financial Analysts Journal that, to our mind, is one of the most insightful of many years. Mr. Martin Leibowitz, Chief Investment Officer of the giant pension fund, TIAA-CREF, writes about The Levered P/E Ratio. The author proves that when valuing a stock for its dividend and growth, the P/E ratio for a high debt issue is not comparable to that for a low debt issue. He develops an example that starts with a debt-free company that is worth a P/E of 30. Mr. Leibowitz then demonstrates that for a company with 30% debt, the comparable P/E would be about 25. For a company with 50% debt, comparable P/E would be 20. The comparison deteriorates rapidly for debt over 50%.
There is an implication for the broader market as well as for individual stocks. The author points out that the debt ratio for the S&P 400 jumped from about 30% in the 1980s to near 50% in the 1990s. Thus the increase in leverage implies that the P/E for the stock market should be lower than historically, other factors being equal.
Mr. Leibowitz, in effect, is writing a sophisticated, mathematical, theoretical, academic, powerful justification of what we have learned over two decades using the McDep Ratio. We had been emphasizing the levered price to net present value ratio in selecting among energy stocks. When megadeals were completed with debt financing, we could see that the levered ratio made high debt stocks look too attractive. Like the author, we reverted to unlevered measurements of Enterprise Value as the term has evolved. Unlevered metrics now seem to be more widely applied in research on energy producers.
Energy producer investors have learned the lesson of unlevered valuation with the painful failures of high debt entities, mostly a decade, or more, ago. Power company investors learned that lesson bitterly over the past year or more as fine old dividend paying stocks collapsed. We have a stark reminder today as we write this as El Paso (EP) slashes its dividend after the stock is down some 90%. High greed partnership investors have yet to learn the lesson of unlevered valuation.