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Unlevered Rate of Return VS Levered Rate of Return


beerbaron
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Hi guys, I wanted to know how you guys tackle Rate of returns between different companies in the same field. For example, the Modigliani–Miller theorem states that two companies with different capital structures should trade at the same level. Are you guys using ROA instead of ROE? Or are you factoring the leverage in another variable?

 

BeerBaron

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I think companies that deploy a more efficient capital structure should trade at a premium to an unlevered/overcapitalized company. 

 

EDIT:  From a market cap valuation perspective, not from an EV perspective obviously.  Also, in todays very low interest rate environment you can create your own capital structure using margin at very low rates which might even be superior to the company taking out debt.

 

 

 

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Hi guys, I wanted to know how you guys tackle Rate of returns between different companies in the same field. For example, the Modigliani–Miller theorem states that two companies with different capital structures should trade at the same level. Are you guys using ROA instead of ROE? Or are you factoring the leverage in another variable?

 

BeerBaron

 

I don't think ROE or ROA would be good metrics to look at in this case because you can have sub-optimal cap structures which would lead to widely different numbers (e.g.: sitting on too much cash or if you buy back a ton of stock your equity base will be low making ROE appear super high).

 

Probably better off looking at a more cap structure neutral metric, EV/EBITDA or similar.

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Ya I tend to look at EV vs CF or EBITDA.

 

I dont mind levered companies, but feel they should trade at a discount. An undercapitalized capital structure allows one to sleep quite peacefully.

 

With that said most of my companies are highly levered. The market gives these things away in times of stress. If you can take it then its a not a bad deal. With dealing with leverage I find its best to focus on the business model, and also the debt schedule. I prefer debt that is 5 years out, and a pretty safe business model.

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Ya I tend to look at EV vs CF or EBITDA.

 

I dont mind levered companies, but feel they should trade at a discount. An undercapitalized capital structure allows one to sleep quite peacefully.

 

With that said most of my companies are highly levered. The market gives these things away in times of stress. If you can take it then its a not a bad deal. With dealing with leverage I find its best to focus on the business model, and also the debt schedule. I prefer debt that is 5 years out, and a pretty safe business model.

 

A levered company should only trade at a discount when comparing cash flow to market cap.  It should actually trade at an EV/EBITDA premium to an unlevered company due to it's lower cost of blended capital. 

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After about 5 years, an unlevered company with a higher ROE will trump a levered company with a lower ROE, by a reasonable margin. A company with high ROE and some leverage will trump both. After 20 years, the difference between a 20% ROE and a 30% ROE is 3x as much money and even 30% debt won't come close to bridge the gap. You would need multiples of debt to equity and even then it's a close battle.

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After about 5 years, an unlevered company with a higher ROE will trump a levered company with a lower ROE, by a reasonable margin. A company with high ROE and some leverage will trump both. After 20 years, the difference between a 20% ROE and a 30% ROE is 3x as much money and even 30% debt won't come close to bridge the gap. You would need multiples of debt to equity and even then it's a close battle.

 

That is all intuitive.  It's mostly because of the compounding, obviously. 

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After about 5 years, an unlevered company with a higher ROE will trump a levered company with a lower ROE, by a reasonable margin. A company with high ROE and some leverage will trump both. After 20 years, the difference between a 20% ROE and a 30% ROE is 3x as much money and even 30% debt won't come close to bridge the gap. You would need multiples of debt to equity and even then it's a close battle.

 

Only 3 times as much?

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Ya I tend to look at EV vs CF or EBITDA.

 

I dont mind levered companies, but feel they should trade at a discount. An undercapitalized capital structure allows one to sleep quite peacefully.

 

With that said most of my companies are highly levered. The market gives these things away in times of stress. If you can take it then its a not a bad deal. With dealing with leverage I find its best to focus on the business model, and also the debt schedule. I prefer debt that is 5 years out, and a pretty safe business model.

 

A levered company should only trade at a discount when comparing cash flow to market cap.  It should actually trade at an EV/EBITDA premium to an unlevered company due to it's lower cost of blended capital.

 

Depends on the industry. If it's a cyclical industry then the risk to a highly levered company overrides in my opinion, and it should trade at a discount. As always it depends on the type of debt, the covenants, the assets, so forth. I'd rather own a small bank levered 15 to 1 and currently earning less than a bank levered 8 to 1 and earning more, if the latter's loan book is 30% construction and land development loans and most of the deposits are brokered, for one example.

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Ya I tend to look at EV vs CF or EBITDA.

 

I dont mind levered companies, but feel they should trade at a discount. An undercapitalized capital structure allows one to sleep quite peacefully.

 

With that said most of my companies are highly levered. The market gives these things away in times of stress. If you can take it then its a not a bad deal. With dealing with leverage I find its best to focus on the business model, and also the debt schedule. I prefer debt that is 5 years out, and a pretty safe business model.

 

A levered company should only trade at a discount when comparing cash flow to market cap.  It should actually trade at an EV/EBITDA premium to an unlevered company due to it's lower cost of blended capital.

 

Depends on the industry. If it's a cyclical industry then the risk to a highly levered company overrides in my opinion, and it should trade at a discount. As always it depends on the type of debt, the covenants, the assets, so forth. I'd rather own a small bank levered 15 to 1 and currently earning less than a bank levered 8 to 1 and earning more, if the latter's loan book is 30% construction and land development loans and most of the deposits are brokered, for one example.

 

Financials are a whole different beast.  Also, it goes without saying a levered cyclical is extremely dangerous and probably not prudent.  ;)

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