How debt can trick you into buying a dud

Companies that are carrying a lot of debt can trick the unwary investor into thinking they're cheap. Phil Oakley explains how to avoid buying a dud stock.

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

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Enterprise Inns51.521.22.438
Punch Taverns116.51.699.5
Premier Foods11.52.353.9

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Sales10001000
Operating Profit (A)100100
Interest @ 5%0-12.5
Profit before tax10087.5
Tax @ 30%-30-26.25
Net Profit (B)7061.3
Shares in Issue500250
Earnings per share (p)1424.5
Row 8 - Cell 0 Row 8 - Cell 1 Row 8 - Cell 2
Equity (D)500250
Debt (E)0250
Share price (p)100100
Market Value of Equity (G)500250
Enterprise Value (G+E) = H500500
Taxed operating profits @ 25% = I7575
P/E Ratio (G/B)7.144.08
Debt adjusted PER's (H/I)6.676.67
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Enterprise Inns26127653026332-8324912.22.4
Punch Taverns732251.72325221-55166141.7
Premier Foods2769101186179-451348.95
Apple492291-7900041329153598-134004019910.312.4

Phil spent 13 years as an investment analyst for both stockbroking and fund management companies.

 

After graduating with a MSc in International Banking, Economics & Finance from Liverpool Business School in 1996, Phil went to work for BWD Rensburg, a Liverpool based investment manager. In 2001, he joined ABN AMRO as a transport analyst. After a brief spell as a food retail analyst, he spent five years with ABN's very successful UK Smaller Companies team where he covered engineering, transport and support services stocks.

 

In 2007, Phil joined Halbis Capital Management as a European equities analyst. He began writing for MoneyWeek in 2010.