Early in my career, I was asked to prepare financial reports comparing different companies for executives to take into their meetings. After reviewing what I produced, one of those executives asked a simple question that would forever change the way I think about balance sheets.
“What is enterprise value?” he asked. I had filled in a number in my report, but it turned out, I didn’t actually know what it meant. Fortunately, he was very kind and explained that enterprise value (EV) was the total value of the company. We can express it in a simple formula:
EV = all outstanding shares x the share price + debt
It was a good lesson because it showed me just how important a company’s balance sheet can be to investors. It also reminded me that debt and its associated costs are something equity investors must consider before buying shares of a business. That’s especially true in today’s higher interest rate environment, where the cost of debt is climbing.
A balance sheet is a financial statement that lists a company’s assets and liabilities. Understanding this statement is a must for every investor. The way a company structures its balance sheet and the amount of interest it pays on its debt can significantly affect a business’s cash flow, which ultimately affects the price of the stock, now and in the future.
There are different ways to look at balance sheets, but here’s what I always pay attention to – even more so in a rising rate world.
1. Understand leverage and valuations.
One of the most important numbers to understand is valuation. Essentially, it’s an estimate of how much a business is worth. While there are many ways to value a company, the point is to give investors an idea as to whether the stock they’re buying is too expensive, too cheap or just right for the price.
Most investors want to buy undervalued stocks, in the hope that the price will increase over time. Others are fine with buying an expensive stock, as long as the business still has strong enough growth prospects for the share price to continue rising in the future.
Valuation and debt go hand in hand. Generally, companies with a lot of debt have a lower valuation than ones with no debt, because an investor has to take on the risk of those loans not getting paid back. Plus, when a company has debt, it has to divert money away from the business to cover the loan and interest. (Debt’s not necessarily bad, though – it can be used to finance growth. But it needs to be paid back.)
With that in mind, one of the most important questions I need answered before buying shares of a company is this: How much cash is available to the business? In other words, how much opportunity does a company have to grow and expand its profitable operations? Again, we can express this in a simple formula, using EBITDA as a proxy for cash flow:
Cash available to pay debt and equity = EV ÷ EBITDA (earnings before interest,taxes,debt,amortization,which is a proxy for cash flow)
This metric is important for companies that have more debt on their books because they can be disproportionately impacted by changes in the company’s valuation. For example, if the EV-to-EBITDA ratio of a stock with no debt (i.e. their EV is entirely comprised of equity shares) falls from 10 to 9, the value of the shares will decline by 10%. But if that happens to a company with the same EV and it consists of 70% debt (i.e. its EV is only 30% equity shares), you’ll see a much bigger drop in valuation.
In both cases the enterprise value declines by 10%, but the indebted company endures a much larger hit to its share price, simply because of the debt that’s on its balance sheet.
2. Consider the impact of interest rates on valuations.
Once you understand how much debt a company has, you can start thinking about how increasing interest rates will affect cash flows and valuations over time. The key metric here is the debt-to-EBITDA ratio. This ratio measures how much income is available to pay down debt before covering interest, taxes, depreciation and amortization costs. Here it is in a simple formula:
Company's ability to pay down debt=company's debt ÷ EBITDA
The ideal debt-to-EBITDA ratio varies by industry, but a ratio below three is generally considered healthy. If the number is higher, you might start to worry about what might happen to the valuation if interest rates climb – or how a small change in EV could impact valuations.
3. Know how different sectors are affected by debt.
Just because a company has a lot of debt doesn’t mean you should stay away. For instance, banks tend to trade at a price-to-earnings ratio of nine, 10 or 11 times earnings, well below where the market usually trades at – which can be, say, between 15 and 17 times earnings. The reason they trade lower is because their balance sheets are massive. They may carry a lot of debt, but they use it extremely well and they're regulated.
With utilities, companies can pass the interest costs on their debt to the end customer. So, over the long term, you’re not as worried as an investor because you know the business will get paid back.
In real estate, companies have term debts – loans that must get renegotiated after a set period of time. If their debt doesn’t mature for, say, five years, you’ll need to think not only about whether the business can cover those debts now, but also in the future. What happens if they have to renew those debts at a potentially higher rate down the road? Can rents rise enough to pay for higher expenses?
Technology and consumer product companies typically use less leverage. They can raise prices in times of inflation, which helps them maintain margins and cash flows.
Ultimately, when we have long-term discussions with management, we’re looking for them to set what we call “a capital structure through the cycle.” Capital structure refers to the combination of equity and debt a company uses to finance its overall operations. Equity is a more expensive, but also more flexible source of capital. Debt is cheaper, but it must be either paid back or refinanced at some point. Businesses need to find the optimal mix. Regardless of interest rates, they need a capital structure where the business can withstand low-interest rate and high-interest rate environments.
4. Pay attention to EBITDA.
Out of all the different metrics I consider, EBITDA is the one I focus on most. The one exception is in assessing a bank, where I focus on capital and liquidity ratios. To put it simply, companies need cash. It’s like oxygen – when it’s plentiful, you don’t think about it, but if you need it, then it’s the only thing on your mind.
5. Take advantage of the spread.
In general we don’t want to have too much exposure to companies that have taken on too much debt. But there may be times when it can make sense. When debt rises, it’s not always due to the quality of the company itself. It may be related to where we are in the business cycle. In these cases, a large-scale investor like RBC GAM may invest in a business in a way that helps it fix its balance sheet. That can translate into great returns for us.
How? Imagine a company as a house. If a piece of property has no debt on it, you will pay full price for it. But if I have to buy the house plus all of its debt, then you expect to pay less. If I can remove that debt and the property is not distressed anymore, the value can rise back to what it’s really worth. As a fund manager deploying a lot of capital, I can capture that spread, where I buy it at a lower price and then sell it at a higher one.
The average investor is not going to buy into a business and pay off its debts, but they should still run these calculations. If you find a company with a low EV to EBITDA ratio, ask yourself, “If the company had no debt, and I paid 100% equity for it, what would it be worth?” If you are confident the business can in fact pay off its debt, then you may do well to invest.