Debt Ratios vs Fundamental Returns on Large Cap Stocks (Part 2/2)


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by Dan Myers

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(Read Part 1 First)

To summarize the first part of this report, I went over the stats of how companies with no debt to debt performed over a 10 year period.

The comparisons involved looking at

  • revenue
  • gross margins
  • EBIT margins
  • and net margins

Here is the final part to compare how companies with debt and no debt compare.

To be able to read the tables and check out the numbers, click the images to enlarge.

Operating Cash Flow Performance Comparisons

The value of a company is based upon the present value of future cash flows. The Income Statement provides a gauge of returns in an economic sense; however cash is where the value lies.

Operating Cash Flow to Revenue

Operating Cash Flow to Revenue | Click to Enlarge

As a percentage of revenue, the debt free company is providing a larger cash flow margin than the debt laden companies.

If we factor in Capital Expenditures (CapEx) we come to our Free Cash Flow (FCF) figures:

FCF/REV

FCF to Rev | Click to Enlarge

Again we see that FCF is higher for debt free companies and diminishes the higher the debt load.

Return on Assets Comparison of No Debt to Debt Companies

Thus far, we have only looked at margins. However, a company can have lower margins and still be a more profitable business if the amount of capital necessary to run the business is small.

The goal of any investment is to increase the returns on the capital you invest in the business.

Thus, even if a company has smaller margins, it may make up for that by utilizing the capital employed in a more efficient manner to replicate the process many times faster than other companies.

EBIT/Assets

EBIT/Assets | Click to Enlarge

Above we show that companies employing more debt actually have a lower return on assets. This number is prior to any interest paid on the debt.

This indicates that the less debt utilized, the more effective management is at utilizing the assets at hand to increase shareholder returns.

Operating Cash Flow to Assets

Operating Cash Flow to Assets | Click to Enlarge

FCF to Assets

FCF to Assets | Click to Enlarge

If we look at this from a cash flow perspective, the story remains the same. Debt does not enhance the returns on assets. In addition, debt increases the variance on those returns.

A Deeper Look at Return on Equity

As an equity investor, we really only care about the returns we are receiving. A firm that employs large amounts of debt can enhance the return on the shareholder’s investment.

The assets may perform less efficiently, but debt magnifies the returns.

Therefore we look at our returns on equity to see if debt is enhancing shareholder value.

ROIC for debt vs no debt

ROIC Compparison | Click to Enlarge

To compare the company’s returns on an unlevered basis, we look at the Return on Invested Capital (ROIC). This shows how effective management is using the capital given to it by both shareholders and debt holders.

The above shows that debt free companies outperform all categories. However, the variance is also higher. It is almost double in absolute terms to the medium to low debt companies.

But it is significantly less than the variance of Medium High and High debt companies.

Debt Free Paper Table 012-13
As for cash flow to equity, debt free companies do not perform as well in operating cash flow and it seems that debt levels have an influence on operating cash flow to equity. However, once CapEx is taken out, debt free companies earning on the higher end of the spectrum.

High debt companies perform terribly.

Debt Free Paper Table 014

Lastly, we look at the returns on equity. Above we show that Debt Free companies perform slightly worse than Medium to Low debt companies.

The discrepancy between ROE and FCF/Equity seems to be caused by CapEx. While companies with debt have a higher return on the income statement and in Cash Flow from Operations, it seems that those return enhancements are offset by the need to spend on CapEx.

It is also important to note that this CapEx appears to be more maintenance CapEx and not growth CapEx. This is supported by debt free companies have larger margins and larger revenue growth.

What’s the Conclusion?

Based upon the data, it appears that the addition of debt does not materially affect the returns of a company.

Revenue is not grown at a faster rate. While Operating Margins are increased, the cost of interest (net of the tax shield) more than offsets this gain.

Also, returns do not appear to fall to the shareholders as ROIC has an inverse relationship with the amount of debt and ROE does not appear to be affected at the lower debt levels.

It is my conclusion that debt free companies seek out opportunities which have a higher return than companies that use debt.

This indicates that rather than levering already high return opportunities, companies use debt to turn opportunities that would be poor investments normally into marginal ones at best.

While the theory may be that the lower return investments are more stable, the variance in the numbers between groups seems to indicate that even if this were true, the cost of debt magnifies the smaller variance to the point where the investment is much riskier than the debt free companies.

Therefore, it seems that debt free companies outperform, from a business fundamentals perspective, debt laden companies while offering lower fundamental risk.

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