"Give me a place to stand on, and I will move the Earth”[1].

When Archimedes, the great scientist of the classical period, said this he was betting on the power of leverage. Although, the Greeks couldn’t give him the “place to stand on”, Archimedes used the principles of leverage to make many great inventions and achieving miraculous feats like moving ships. His contributions to science are so great that it hardly matters that there is now enough evidence to prove that he wouldn’t have been able to move the earth, after all.

But the similar attempts to ‘move the earth’ by many of today’s businesses, using financial leverage, cannot be seen in the same encouraging light. In this article I will describe the concept of financial leverage and how to analyze the companies with heavily leveraged capital structures.

In finance, leverage means using debt to supplement existing funds for investment. Because the debt has a fixed cost in percentage terms, leverage tends to magnify the returns (both positive and negative) to the shareholders.

To understand this, let’s assume two companies A and B each having a networth of Rs 1,000Crs. Company A invests it in a business without taking any debt. Company B adds Rs 1,000 Crs by taking debt and thus, puts the total 2,000 Crs in the same business as A. Company A earns pre tax profits at 20% of their invested capital after accounting for all operating expenses and depreciation. Company B, impacted by the law of diminishing returns, earns 18%. Suppose B pays 10% as interest on the debt. Both companies pay 25% tax on the profits. Here is what the results will look like.

 Company A B Debt 0 1,000 Equity 1,000 1,000 Invested Capital 1,000 2,000 Return on investment 20% 18% Profit before Interest and Tax (PBIT) 200 360 Interest 0 100 Profit before Tax 200 260 Tax 50 65 Profit after tax 150 195 Return on Networth 15.00% 19.50%

*All amounts are in Rs Crs

As you can see, the company B earns higher percentage returns for the shareholders even when its returns on the capital are lower. This is due to leverage. Every penny earned by B, after paying the interest on debt goes to the shareholders. In addition, the interest paid by the company is not subject to tax. This makes leverage an interesting proposition for the corporations.

However, leverage cuts both ways. If the business goes through a bad phase and both the companies just break-even after accounting for operating cost and depreciation, the company B will slip into red. This is because it has to pay 100 Crs interest irrespective of the returns made on the borrowed funds. If the company fails to pay the interest, it would be considered a default and the creditors can take control of the company. This risk is significant in case of prolonged downturns in businesses, which are not so rare.

Leverage makes decision on optimal capital structure quite tricky. Not surprisingly, if you are an investor, you will come across capital structures ranging from debt-free companies to highly leveraged companies. The same logic drives many more exotic businesses like hedge funds, leveraged buy outs, etc. An extreme example is the hedge fund Long-Term Capital Management (LTCM) that had borrowed over \$124.5 billion on equity of \$4.72 billion, for a debt to equity ratio of about 25 to 1. When it failed, LTCM also became the prominent example of the risks inherent in leveraged investments.

Leverage is not limited only to corporations. It is not difficult to find individuals who have taken housing loans worth 10 times their networth and so high compared to their annual savings that it would take them 30 years to repay the loan. If the real estate prices move up, their gains are magnified due to leverage and so is their risk to go bankrupt in case the housing prices fall and interest rates rise.

Leverage is the single biggest factor responsible for bringing the world economy to its knees and prompting knee jerk reactions from central banks and governments all over. In a scenario of highly leveraged investments, how do we value these companies? Let me explain it with an example.

Wockhardt Ltd, a leading pharmaceutical company in India, ended the year 2003 on a cheerful note. It had 460 Crs of networth and 330 Crs of debt. It earned 18.8% on capital which translated into 28.6% return on networth (due to leverage). Between Dec 2003 and Sept 2008, the sales increased 3.6 times and profits before interest and tax (PBIT) went up 4.4 times. However, the company’s market capitalization fell 61%. Today, it is available at a 10% discount on the book value and mere 5.9 times its consolidated profits during the last 12 months.

Is this not a sure shot value buy? Should you follow the contrarian approach and buy this beaten down stock? Recessions do not affect pharmaceutical companies the same way as they affect other sectors. What do you think?

Deciding to buy a stock by looking ONLY at the profit loss statements or results is as foolish as choosing a life partner after seeing a photograph and a one-page profile. That both these things happen in this world does not change the fact that it is as idiotic as it can get. A business which is funded by a mix of debt and equity earns the returns for both the creditors and the shareholders. The creditors have prior right to the returns and after they are paid their cut in the form of interest and the tax is paid, the shareholders get their returns. A part of the returns is invested back in the business and the rest paid as dividends. If you understand this, you will realize that accounting results do not give the full picture.

Nothing shows this argument more dramatically than the Wockhardt case. The charts below compare the state of Wockhardt in December 2003 to the state today. Today, a huge 70% of the capital invested in Wockhardt comes as debt (see the outermost circle). That’s why you see 74% of the enterprise value (debt + market cap) of the company is allocated to debt (see the circle in the middle). The creditors are paid 40% of the returns generated from the business as interest (see the inner most circle).

Even so, what explains the huge undervaluation of the stock? The reason is the risk imposed by excessive leverage. The interest on the debt is not fixed. When the company’s short term debt matures it will not be able to secure loans at the interest rates it is paying on the low cost debt amassed in the past few years. This can lead to severe problems explained in the article ‘Anatomy of a debt trap’ in the previous issue of Unfair Value.

That brings us to the process of valuation of a leveraged company. A company with high or changing leverage cannot be valued using discounted cash flow to equity. It should be analyzed by what is called as Free Cash Flow to Firm (FCFF) defined below[2].

The free cash flow to the firm (FCFF) is the sum of the cashflows to all claim holders in the firm including the stockholders, bondholders, and preferred stockholders.

FCFF = PBIT * (1 - tax rate) + Depreciation – Capital Expenditure – Changes in working capital

In layman terms, FCFF looks at all the cash accruing to the stakeholders (stocks, bonds and preferred stock holders) without differentiating how the cash is distributed. It takes into account the tax benefit on interest payment (tax is levied on profits after deducting interest). Out of this cash, we pay interest to the lenders, preferred dividends to the preferred stockholders and then, if any cash is left, it is partly paid as dividends and the rest is reinvested into the business.

In any company where the funding by way of debt and preferred stocks is significant, the measures like P/E, RONW and book value do not give a complete picture of the financial situation. The fact that Wockhardt sells at 10% discount on book value and 5.9 times its last 12 months profits is of no consequence, if you notice that it is funded so heavily by debt.

If you ignore senior securities and their prior claim on assets and profits earned by the business, your fate will be similar to the fate of the jackal in Aesop’s fable who went on a successful hunt with a lion and a wolf. When the turn came to divide the killed stag, the lion roared: "Quarter me this Stag”. The wolf and Jackal skinned the stag and cut it into four parts. Then the Lion took his stand in front of the kill and pronounced judgment:

“The first quarter is for me in my capacity as King of Beasts; the second is mine as arbiter; another share comes to me for my part in the chase; and as for the fourth quarter, well, as for that, I should like to see which of you will dare to lay a paw upon it."

References

1. Quoted by Pappus of Alexandria in Synagoge, Book VIII

2. Investment Valuation Tools and Techniques for Determining the Value of Any Asset Valuation By Aswath Damodaran
Chapter: Free Cash flow to the Firm

Unknown said...

Hi Kamlesh,
I have been going through your articles regularly. Though some of the stuff is known, it is still a pleasure to refresh our knowledge of investments every now and then. Keep up the good work.
Regards,
Kaviraj

Anonymous said...

Genial dispatch and this enter helped me alot in my college assignement. Thanks you on your information.

Anonymous said...

Hi
Very nice and intrestingss story.