On Mon, Mar 03, 2003 at 12:43:00PM -0600, Dan Minette wrote:
> The measures of performance that I know of do not appear to favor
> debt financing. Maybe RONCE does, because its net capital, but other
> figures, such as equity, PE ratio, the Acid test, all favor lower
> debt.
No, they do not favor lower debt. P/E is a valuation measure, equity is
just that (sometimes called owner's equity), and acid test is just a
measure of liquidity. And RONCE, which is closely equivalent to but less
commonly used than ROIC (return on invested capital), is used for just
the opposite, to look at returns INDEPENDENTLY of how the company was
financed. None of these are particularly relevant to the decision of how
to finance the company. Remember that owner's equity is usually accounted
for on the balance sheet as a liability, so
What you want to look at are measures of business quality. Things like
return on equity (ROE) and economic value added (EVA).
To start with a commonly used, but usually too simplistic measure, look
at ROE:
ROE = earnings / equity
= (profit margin) * (asset turnover) * (leverage)
All other things being equal, higher debt (more leverage) will result in
a higher ROE. But this is often too simplistic. It is possible for two
companies to have identical ROIC's but very different ROE's.
The commonly accepted measure for financing capital projects is economic
value added. I mentioned this in my previous post.
EVA = (ROIC - WACC) * IC
EVA is equal to the invested capital (IC) multiplied by the difference
of return on invested capital and the weighted average cost of
capital. If a company is entirely debt financed, the WACC is simply
equal to the interest rate they are paying on their loans or bonds. On
the other hand, if the company is entirely equity financed, then WACC
is more difficult to determine. It can be thought of either as the
opportunity cost of investing the capital in a given place (i.e., what
rate could the capital earn elsewhere?), or as the sum of a "risk free"
interest rate (eg., the rate offered by the US government on TIPS,
treasury inflation protected securities) and the risk premium, which
measures the additional return required by investors for taking on
investment risk.
So, when evaluating whether to allocate capital to a project, one looks
at EVA. If it is positive, then it is a value creating project. But if
there is a limited amount of capital available (there always is) and
more than one possible use for it, the capital should be allocated to
the highest EVA projects first. That generally means minimizing the WACC
through judicious choice of debt or equity funding.
The WACC for equity funding is almost always higher than for debt
funding (for a low-debt company). However, taking on too much debt
increases the risk of the company and increases the WACC, so there is
a limit to the debt that can be taken on. But companies today have
historically high debt to earnings ratios, and I think many have too
much debt which makes the market excessively volatile and, for certain
companies which cannot be allowed to fail (eg., LTCM or Fannie Mae),
risks taxpayer money.
http://www.capatcolumbia.com/Articles/FoStrategy/Fos1.pdf
http://www.fool.com/school/howtovaluestocks.htm
http://www.geocities.com/andrewychan/files/EconomicModelV20a.pdf
> From what I've seen personally and in general, leadership teams tend
> to work to make stock analysts write good reports that drive stock
> prices up.
The bad ones do. The good ones follow something like the EVA approach to
allocating capital.
> The only strategic reason for massing debt that I've seen have been
> attempts to become a less attractive takeover candidate. Indeed, I've
> heard many times that a company cannot afford to have too low of a
> debt ratio for just this reason. But, that is quite different from a
> finance by debt vs. finance by stock question. Indeed, it seems clear
> to me that the decrease in going public is a reflection of low stock
> prices not tax policy.
The decision is more complicated than you seem to think. Read the links
I referenced above and some of the links they reference to get a better
idea of how it should be done.
> In addition, business taxes (as a fraction of GDP) have gone down by
> more than a factor of 2 (the average for the '50s was 4.8% of GDP, the
> average for the '90s was 2.0%) over the last 40 years or so. During
> the same time, social security taxes have gone from 2.0% to 6.6% of
> GDP. So, if business taxes are the issue, why is corporate debt
> higher than it was when business taxes were higher.
As I said before, the tax laws tend to favor debt over equity. Interest
payments on debt are deductible to the corporations; dividends on equity
are not. I don't mean to say this is entirely responsible, but it is a
factor.
> I really don't have an argument with this statement, just a passing
> observation that the most successful corporation of the late 20th
> century that I can think of (M$) has yet to pay a dividend.
You can only say that for 3 more days...
Also, for every Microsoft, there were hundreds of growth companies
that failed to produce value for their share-holders. Few companies
can sustain a competitive advantage for so long and have positive EVA
since their ROIC will usually tend to converge to the WACC quickly as
other companies enter the field. Only businesses with a "wide moat"
like Microsoft can profitably sustain growth. Most others will destroy
shareholder value as they grow. They are better off to stop growing when
EVA = 0 and simply pay a dividend (or buy back their shares).
Keep in mind that in the long run, all companies disappear. If the stock
is to be anything other than a pyramid scheme, managers must at some
point either pay a dividend or buy back shares. If a company never pays
a dividend nor buys back shares, it is worthless.
The value versus growth debate has raged forever, but I think it is
quite telling the value stocks have outperformed growth stocks in total
return by an annualized rate of 3% to 4% since 1927. Since growth stocks
pay smaller dividends than value stocks (often no dividends), this means
that dividend paying stocks tend to beat non-dividend paying stocks.
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
_Triumph of the Optimists_, Dimson et al.
> Well, let me explain in more detail. I think that the foundation of the
> creation of wealth is improvement in productivity.
Agreed.
> Improvements in productivity can, but need not come from business
> owners. An example that I give is the $5.00/barrel cut in the price
> of oil came from the work of engineering groups. I happen to know the
> two people who were most responsible for one of the two innovations
> that are at the foundation of this. They were employees, not owners.
But without the owners, would they have been able to do it? Could they
have supported themselves over the years and worked out of their garage
to create it?
I'm an engineer so I have some empathy with your viewpoint, but I also
realize that I don't usually like to get involved with the marketing and
financing game (it seems less than honest to me, and the rules of the
game are so ambiguous compared to engineering problems). But without
marketing and financing, I wouldn't have the "toys" I need to think up,
design, and produce the products that I do.
> But, by the same token, the folks around me who had a third of a
> million, a half million, a million of stock in their portfolio who
> believed that we were in a new economy where the market would always
> go up were part of the "euentrerprenure class" and would benefit more
> by this tax cut than an across the board tax cut. I don't see them as
> a major source of economic growth.
I agree they behaved quite idiotically. I've had some direct experience
with VC's in the telecom component industry, and they often seem
clueless to me. But they seem to be much more cautious these days. I'm
not really sure what to think about them, now. There have been some huge
mistakes made in capital allocation throughout the telecom and fiber
optics industries, from components up to networks and laying cable. On
the other hand, the bandwidth available to everyone has gone up at
incredible rates in the past 15 years, much faster than Moore's law for
computing power. It will be interesting to see how it looks 15 years
from now.
> While most creative people that I know like to make more money, it is
> not the prime reason for creating. The satisfaction of being able to
> see the product of one's own work rates higher. Indeed, most studies
> on workplaces that I've seen stated that work conditions tend to have
> a greater impact on job satisfaction than anything else.
I think that may be a bit self-fulfilling. Those who value satisfaction
more than money become engineers, artists, scientists, teachers,
etc. Those who value the money and/or power become executives and
lawyers.
> There is also the point that having wealth is a positive feedback
> mechanism. With the elimination of estate taxes and the fertility
> rate of the wealthy being at or below 2, we have a situation where
> family money can be passed on to the next generation without a serious
> reduction. This is a risk to the stability of the US. If we get to
> the point where 5% of the people have 99% of the net wealth, and 1%
> have over 50%, what stake in the system will the other 95% have?
Good question. I think estate taxes are a wonderful thing. They give
each new generation a fair crack at getting some wealth, leveling the
playing field. Shame on the politicians who oppose them!
--
"Erik Reuter" <[EMAIL PROTECTED]> http://www.erikreuter.net/
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