How debt can trick you into buying a dud

Price/earnings (p/e) ratios are popular when valuing companies. It's not difficult to understand why. On the face of it, they are easy to calculate and understand. But they also make investors lazy and prone to ignore the big risks. A low p/e doesn't always mean stocks are cheap. This is particularly true of stocks with lots of debt. These should have low p/e's because they are more risky. Let me explain why.

Three companies with lots of debt

Enterprise Inns, Punch Taverns and Premier Foods have very low price/earnings ratios. They also have lots of debt. Credit rating agencies look at the ratio of debt to EBITDA, or earnings before interest, tax, depreciation and amortisation (a proxy for a firm's gross cash flow) when looking at the creditworthiness of a company. For non-financial or utility companies, any number above three would be considered high. But are the shares of these three companies cheap? We don't think so.

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Enter the debt-adjusted price/earnings ratio

We don't like debt here at MoneyWeek. It can make you look very clever when things are good, and very foolish when things are bad. Too much debt is very risky for investors. It also distorts p/e ratios.

Take a look at the table below. Andy's Ices and Bob's Cones are almost identical businesses. They have the same sales and profits but they are financed differently. Andy finances his business with equity, whilse Bob uses equity and debt.

With both having a share price of 100p, Andy's Ices has a p/e of 7.1x while Bob's Cones trades on a p/e of 4.1x. Bob's business is cheaper than Andy's according to this measure.

Common sense should tell you that this is nonsense, and a debt adjusted p/e ratio proves this. When you buy a business in its entirety, you are buying all the assets that can be financed by debt or equity in return for some operating profit. The price you pay is known as the enterprise value (EV). You calculate this by adding the market value of equity (share price x no of shares) and the firm's net debt.

As you can see, Andy's Ices and Bob's Cones have the same EV of £500m. This makes sense as they also have the same operating profits and same growth prospects.

Interest on £250m of debt reduces Bob's tax bill compared to Andy's. It also reduces his p/e ratio. This is because the firm's equity value (EV less debt) reflects the whole amount of debt (£500m-£250m) but net income only falls by the after tax amount of interest (in this case £8.7m).

By stripping out the effect of debt, the debt adjusted PER shows that these identical firms have the same p/e of 6.7x.

The lesson here is that by buying shares in Bob's Cones you think you are buying a cheaper stock, but you are not. The debt means you are buying a more risky stock - and this is why the p/e ratio is lower. You need a higher return to compensate for a higher risk. To highlight this, invert the p/es to get an earnings yield (1 divided by the p/e ratio). Debt free Andy's Ices has an earnings yield of 14% (1/7.14), whereas Bob's Cones has an earnings yield of 24.5% (1/4.08) to reflect the higher risk.

Companies with lots of debt look cheap for a reason

If we return to our original three companies, you can see that the debt adjusted p/e ratio makes them look much more expensive. For Enterprise Inns and Punch Taverns, there is a huge difference between normal and debt adjusted p/es. Try this approach on banking stocks and it gives you a good enough reason to avoid them.

This approach also works in reverse. Companies with lots of surplus cash have lower adjusted p/e ratios. (Cash adds to market value, whilst interest income adds a smaller proportion to net profits). As you can see, Apple even after its stellar run could still be very cheap.