Fools should keep their eyes peeled for at least one item on a company's balance sheet: long-term debt. Since the dawn of time, it seems, both academics and investment professionals have studied capital structure in an attempt to determine a company's optimal level of debt versus equity. Here's what you should know.
Borrowing from Peter to pay Paul
The press has been buzzing lately with accounts of activist shareholders advocating that companies need more debt in their capital structure. Indeed, a number of companies have actively issued debt solely to fund repurchases of their common stock, thus reducing share count and magnifying earnings per share. Since that strategy leaves less equity floating around on the market, it can also improve a company's return on equity. Historically low interest rates, which make it less expensive for companies to issue debt, have helped to drive this trend.
Need a high-profile example? Witness the recently ended discussions between Motley Fool Stock Advisor pick Time Warner (NYSE: TWX ) and the king of shareholder activists, Carl Icahn. Among other things, Icahn recommended -- or should that be "demanded?" -- that Time Warner adopt a "more appropriate" capital structure. Supporters of the deal pointed out that using debt issued at record low interest rates to buy back shares would not only increase earnings per share, but lower the company's weighted average cost of capital (WACC, or the weighted average of debt and equity costs, determined by the mix of the two elements in the company's capital structure) to below its earnings power.
Icahn didn't get the bulk of his demands, but Time Warner management did agree to issue billions more in debt to fund share repurchases. Opponents speculated that the moves Mr. Icahn suggested only amounted to short-term adjustments to the company, meant to temporarily boost its per-share earnings and share price.
Conventional wisdom notes that the cost of debt capital is usually lower than the cost of equity capital. There are a number of ways to calculate the cost of debt, while the cost of equity is not an explicit cost per se; instead, it represents a return that investors require for holding shares of a stock. Depending on the overall risk profile of a relatively developed company, it can range from approximately 10%-15%.
We noted above that higher levels of debt lower the overall WACC, while offering a favorable tax deduction on interest costs. When it takes on too little debt, a company's WACC is seen as too high, putting it at a disadvantage to its optimally leveraged competitors. Financial theory states that the lower its WACC, the more optimal a company's capital structure becomes. That means more debt is a good thing -- until the risk of bankruptcy starts to become too high.
The Oracle weighs in
According to Foolish wisdom, a company's raison d'etre is to earn above its cost of capital (as measured by return on capital). So is it appropriate to adjust the capital structure solely to lower WACC and improve earnings? Let's see what Warren Buffett of Berkshire Hathaway (NYSE: BRKa ) (NYSE: BRKb ) has to say on the subject.
The Oracle of Omaha devoted a section of his recently released shareholder letter to the subject. In the "Debt and Risk" section, he explained, "We are not interested in incurring any significant debt at Berkshire for acquisitions or operating purposes." The company has hundreds of thousands of shareholders with large sums invested, and any disaster in the company's capital structure would be, well, disastrous. The only way for Berkshire's insurance businesses to protect holders of individual, high-limit, or catastrophic-insurance policies is to "have the net worth, earnings streams and liquidity to handle the problem with ease." There were three cases where Berkshire took on debt, each related to a specific operation. The most significant involved its utility MidAmerican, which has a high, predictable earnings stream because of its property diversification.
Advice from M&M
Is playing with a firm's capital structure nothing more than financial maneuvering? Does it have anything to do with the business's underlying operations? If you've ever taken business classes, you may recall that academics Modigliani & Miller (M&M) have one answer to those questions. They developed a now-ubiquitous financial theory stating that a firm's market value is determined by its earning power and the risk of its underlying assets. M&M assert that market value doesn't depend on how the company chooses to finance its investments or distribute dividends. The theorem gets much more complicated, but the basic idea is that under certain assumptions, it makes no difference whether a firm finances itself with debt or equity.
We Fools generally gauge a company based on the value of its free cash flow, discounted back to today at the appropriate cost of capital. Debt merely reduces the cash left over for shareholders (since interest expense eats up capital, regardless of how much it saves in tax deductions). And if an extreme shock hits the economy or the financial ecosystem, debt can quickly cause a company to go the way of the dinosaur. As the Oracle succinctly points out: "Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero. That is not an equation whose effects I would like to experience personally, and I would like even less to be responsible for imposing its penalties upon others."
The answer is.
So what is the appropriate level of debt for a company? In an ideal scenario for the long-term Foolish investor, a company wouldn't have to employ debt at all. It could rely instead on an economic moat capable of earning well above its cost of capital. In the real world, however, things aren't so black and white.
As a good rule of thumb, a debt-to-capital ratio below 40% is generally considered low; a ratio of 40%-60% starts to become a concern; and a ratio greater than 60% is definitely cause for concern, since any external shock or protracted downturn in the business can lead to liquidity issues. Of course, the type of business and the predictability of its cash flows are important considerations. Consumer companies such as Anheuser-Busch (NYSE: BUD ) and Colgate-Palmolive (NYSE: CL ) have strong recurring cash flows, which allow them to maintain debt-to-capital levels near 70% without losing their appeal as solid investments.
It's worth noting briefly that return on capital is a superior metric compared to return on equity, since the latter can be inflated if a company takes on too much debt.
Issuing debt to repurchase shares looks like a short-sighted way to boost EPS. To best create long-term value, a company should focus on growing free cash flow at a reasonable rate over extended periods of time. It's best for a company to avoid debt, but when push comes to shove, it's more important for that company to earn returns on capital that exceed its WACC.
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Anheuser-Busch and Colgate-Palmolive are bothMotley Fool Inside Valuepicks. To discover more of the market's best bargains, sign up today for a free 30-day guest pass.
Fool contributor Ryan Fuhrmann has personal debt levels that would make the Oracle proud. He is long shares of Time Warner but has no financial interest in any other stock mentioned (that means he's neither long nor short the shares). Feel free to email him for feedback on this article or to discuss capital structure further.