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This is a guest post by Daniel Myers.
The following report was born from a healthy discussion from the OSV stock forum related to how the returns differ for companies with low or high debt.
To answer this question, Daniel went about on a personal quest to find the answer and wrote a report on his findings.
Due to the length of the report, it has been broken up into into two pieces to make it easier to digest.
I will now turn it over to Dan.
The Data Set and How this is Constructed
I pulled the financials of the top 490 companies by market cap as listed on Finviz.com. Banking and REIT equities are excluded due to their financials being different from normal businesses.
Non-US companies were also excluded to ensure the accounting was similar.
The data was pulled using the Old School Value stock analyzer which pulls data from Morningstar.
The data is taken at face value and is assumed to be accurate. No independent verification was performed.
The data set was based upon large cap companies to avoid companies that do not have access to debt markets. It is assumed that a company with a market cap of over $6 Billion will have the ability to access the debt market if it so chooses.
Large cap companies are also used to minimize survivorship bias.
The data was pulled in September 2013 and goes back as far as 2003. Some companies in the data were not publically traded for the entire 10 years and thus have no data for those time periods.
These companies are excluded from the data set for that particular year. They are included in the years where data was supplied.
In the first year, 403 companies that are currently in the top 490 had information provided. The number of companies increased each year as more and more companies in our data set became public.
Since a company’s capital structure can change over time, a particular company may move from one bucket to another from year to year.
As companies move into another bucket, their data for that particular year will fall into the bucket their balance sheet dictates for that year.
Companies were split into 6 categories based upon their capital structure. Capital Structure was determined based upon the ratio of debt to assets.
The following formula was used to calculate the capital structure.
Debt Ratio = (Short-Term Debt + Long Term Debt)/Total Assets
A company was placed in a category based upon where that ratio fell in that particular year:
X= Debt Ratio
No Debt: x = 0
Mid Low: .2<x<.4
Mid High: .6<x<.8
The Methodology. Not Rocket Science.
Based upon the data provided, each metric described below uses the median value for a particular data set.
A median value is used instead of an average to ensure that one or two outliers do not skew the data. Given that we are using percentages in our metrics, one company with very large losses or gains would skew the data.
On appropriate metrics, the Compound Annual Growth Rate (CAGR) is used to determine the long term growth of a particular metric.
CAGR is superior to an average as a negative number will skew the results. A company that has a 25% drop in revenue would need a 33% increase in revenue to come back to its starting point.
An average would show a 4% annual increase in revenue when there really was no growth.
Standard Deviation is used to determine how stable the categories metric perform. This is shown as “Variance” in the tables. Absolute Variance measures what percentage of the value that represents.
A 1% standard deviation on a 5% metric would represent 20% of the value. However, it would only represent 2% of the value on a 50% metric.
Thus a 1% deviation is more important the smaller the number is.
Abs Variance = (Variance)/(CAGR) or (Variance)/(Average) depending on the metric.
Here’s the Hypothesis
Traditional finance theory states that the use of leverage enhances returns to shareholders.
Those returns can come in a variety of forms.
The returns can also be some combination of the following:
- Revenue Enhancement: Debt can be used to increase revenues through opening new sales locations, creating new products, increasing production, acquisitions etc.
- Expense Reduction: Debt can be used to reduce costs. Purchasing equipment can make the process more efficient or reduce the amount of labor involved. Per unit savings can be made with volume discounts. This would enhance margins through economies of scale.
- Leveraged returns: The owners of the business using leverage would be able to have less capital at risk given the same sized business. Since the owner of a corporation is only risking the capital they have in the corporation, the owner has reduced his personal capital’s business risk. With lower capital invested, the owner’s returns are enhanced as the returns are now a larger in proportion to the investment.
How does Revenue Enhance Shareholders?
One possible enhancement to shareholder return through debt would be through growing revenue.
A company with additional capital could increase production and sale through the use of additional capital.
When I tested the median revenue growth for the 6 categories, what I found was the following.
Based upon this data, it appears that debt free companies actually grow revenue at a faster pace than companies with any level of debt.
While it is true that High and Mid High debt companies beat No debt companies in a couple of years, compounded over a decade, No debt companies grow revenue at approximately 15% which is almost 4% higher than the nearest bucket. In addition, the deviation of the revenue growth is lower the less debt a company has.
Furthermore, absolute variance is lowest on debt free companies.
This runs counter to the theory that the more stable a company is, the more it can use debt in its capital structure.
In fact, it appears that the more stable revenue growth is, the less debt a company uses.
Also, companies are not using debt to increase revenue.
Debt free companies are growing revenue faster. Thus if debt enhances returns, companies must be using debt in other areas.
How the Margins Look Across Different Levels of Debt
If companies are not using debt to enhance revenue, it is possible that a company is increasing margins on the same revenue. This could be through capital efficiencies, vertical integration, economies of scale or other cost saving plans.
A company could enhance shareholder profits through cost savings.
The table above shows that the two extreme’s (no debt and high debt companies) maintain significantly higher gross margins.
No debt companies are slightly higher and also have a smaller variance than high debt companies. This leads us to believe that there is no enhancement to gross margin by employing leverage.
An alternative hypothesis could have something to do with the economic moats.
- Companies with an economic moat or large barriers to entry will generate large amounts of steady predictable cash.
- A company with a steady predictable cash flow can either pay off debt with those cash flows and eventually become debt free or enhance their debt level to enhance returns on that cash flow.
- To further the point, a company with high margins must have some form of economic moat. Otherwise, competitive forces will drive that margin down.
This table leads us to believe that gross margin may be a cause rather than an effect of debt levels.
Earnings Before Interest and Taxes (EBIT) is a measure of the operating performance of the business.
The table above indicates that higher debt companies are able to enhance their returns by using debt to reduce operating expenses. Since this ratio is dependent upon revenue, gross margin and operating costs, we can deduce that debt is being used to reduce operating costs mainly.
Revenues are not enhanced and nor is gross margin.
In addition, the variance of EBIT Margin is inversely related to debt levels. The larger the debt load, the higher the variance is in EBIT margin.
While High debt companies have higher margins, those margins are subject to a higher variance.
While high debt companies may have larger EBIT margins, the question becomes whether or not that increase in margin overcomes the interest costs associated with taking on debt.
We look at Income Margin which includes tax expense. The reason we take this into account is due to the tax shield provided by the interest expense. Based upon the table above, it is clear that Net Income Margin is severely reduced by the employment of debt.
The more debt a company takes on, the lower the margins. In addition, the variance begins to become larger as the debt load reached over 80%.
This would be in line with the risk reward correlation used to justify leverage. However, the margins do not justify it.
To be Continued…
In the final piece of this two part series, I will look at operating cash flow, FCF to Revenue, ROA and ROE to see whether having debt affects the returns of a company.
Part 2 Has been Published
Go read the final part and download the paper too.
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