Back when I was in business school, we were taught that in valuing a company, there's effectively no difference between debt and equity financing.
Now, that may seem counterintuitive -- in equity financing, a company offers stock in exchange for capital, while in debt financing, a company borrows from a lender in exchange for capital. You're either diluting your stake in the business or in hock to a creditor. Sounds a lot different, doesn't it?
A group of Nobel economists, though, put out a theory widely taught in business schools around the country. Quoting Investopedia:
The market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends. ... The basic idea is that, under certain assumptions, it makes no difference whether a firm finances itself with debt or equity.
That's fine in the academic world, with lofty assumptions like efficient markets and equal access to information. But as it plays out in real life, I can't agree with that theory -- and I'd guess that CEOs who overleveraged their companies (and are now in great trouble) probably side with me.
See, economic activity is cyclical -- not linear -- so if you have too much debt to handle the down phases of the business cycle, you'll get in trouble. If you miss enough interest payments on your debt, you're going to file for bankruptcy protection. If you skip dividends, you anger your shareholders and your stock goes down, but you have more money to put the company on the right path to profitability -- after which you can do things like begin paying dividends again.
Think of the distinction this way: By definition, debt investors are concerned with the return of capital. Equity investors are concerned with the return on capital. That one word makes a mountain of difference.
Corporate financing follies
Let's look at some real-life examples. I recently wrote about why Rio Tinto
In every industry, the overleveraged companies pay dearly when a crisis strikes. For every overleveraged Lehman, there is a more liquid Goldman Sachs
When there's too much debt in the system
Of course, Wall Street is hardly the only place in America where debt has piled up. We can point to the spectacular corporate, consumer, and government debt binge as the root of today's economic problems. I believe this recession will last longer than usual because of that binge, with any recovery likely to be muted. (To some, it may not feel like a recovery at all.)
On the consumer level, just look at one of the housing boom's great financial innovations: the negative amortization loan. With these loans, the borrower did not have enough income to service the loan, so part of the interest got added to the principal every month. The assumption here was that an ever-growing loan is no problem, because that house would obviously appreciate forever. As we all know now, that assumption didn't turn out so well for anyone.
Position your portfolio
So how can you position your portfolio against an unwinding debt binge?
Very simply, be cautious of companies with onerous debt loads. The easiest way to do this is to check a company's debt-to-equity ratio and compare it with industry peers -- the higher the ratio, the more leveraged the company.
And remember: If a company doesn't stay current on its debt, it usually files for bankruptcy. Companies like MGM Mirage
To anyone who may have heard the nonsense that there is no difference between debt and equity financing, I recommend you stick to the advice of Mark Twain and not let your schooling interfere with your education. Because there's a big difference.
More on debt issues:
At Motley Fool Stock Advisor, Fool co-founders David and Tom Gardner always look closely at company financials when making stock recommendations. See which companies they like with a free 30-day trial.