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Imaginary debt can be a good thing if...

Mar 15, 2012

Value investing, in simple terms, is selecting and buying stocks which are trading below their intrinsic value. While there are many themes of value investing, the common rule is for investors (following this process) to protect the downside while investing in equities.

In this article, we will be looking at the basics of one such theme - debt capacity bargains.

The original idea behind this methodology was written by the father of value investing, Benjamin Graham, in his book 'Security Analysis'. A key idea behind this concept is of a company being worth much more than the amount of debt it can easily service.

But before we further dive into this, let's take a step aside and get familiar with a few terms which will help us understand this concept better.

Interest coverage ratio - The interest coverage ratio is used to determine how comfortably a company is placed in terms of payment of interest on outstanding debt. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense for a given period. As such,

Interest coverage ratio = EBIT/ Interest expense

For example, if a company has a profit before tax (PBT) of Rs 100 m and is paying an interest of Rs 20 m, its interest coverage ratio would be 6 (Rs 100 m + Rs 20 m / Rs 20 m). Therefore, the lower the ratio, the greater are the risks.

If one wishes to take a more conservative approach, one could calculate the interest coverage ratio on the 'net cash from operating activities'. As you would be aware, cash flow from operating activities is the amount of money a company makes (or loses) through its operations. Only the "core" operations must be taken into consideration under this head of the cash flow statement.

Debt capacity - Debt capacity is the debt taking ability of a company. It refers to the amount of funding that a company can borrow to the point of not compromising its financial viability. We will explain this further with the help of an example.

Company XYZ has an average EBIT of Rs 100 m over the last five years and has no debt on its books. If a bank wants to loan funds to the company, it would gauge, amongst many other parameters, XYZ's ability to pay its interest costs comfortably. By assigning a conservative interest coverage ratio of 3x i.e. three times (a very subjective figure), XYZ A can comfortably service interests costs of Rs 33.3 m a year. Let's assume the interest rate to be 10%. This means that a bank would comfortably give XYZ a loan of Rs 333 m and would be assured that the company would be able to service the debt comfortably. As such, Rs 333 m becomes XYZ's debt taking capacity.

Coming back to the main discussion of this article - as per this method, if the market capitalization of a debt free company is less than the amount of debt that the company can comfortably service, then the stock becomes a 'debt capacity bargain'.

Mr. Graham's logic behind the same concept is explained well in his book 'The Intelligent investor'. He wrote - "There are instances where an equity share may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only equity shares that under depression conditions are selling for less than the amount of the bonds that could safely be issued against its property and earning power. In such instances the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in an equity share."

What Mr. Graham is essentially stating is that if the bank has claim to one-third (depending on the assumed interest coverage ratio) of the EBIT (or cash flow after operating activities depending on one's conservativeness), why wouldn't an investor want to purchase a stock of a company whose market capitalization is below that of its debt taking capacity. This effectively means, that lower the market cap of a company as compared to the debt capacity, the more share of the profits an investor would get.

Considering that the short listed companies would be debt free, or may be nearly debt free, the last step would be to add the net cash figure to the debt capacity. One could consider taking a look at stocks whose market cap would be lower than that of the outcome of this calculation.

But, it would be important to note that not all companies that fulfill the above-mentioned parameters would be a good buy. A proper due diligence would be very much required. As such, investors could use this concept to shortlist stocks for further research.

Devanshu Sampat

Devanshu Sampat (Research Analyst) has a degree in commerce and nearly 5 years of experience in equity research. He draws inspiration from successful value investors across the globe and constantly endeavours to refine his own unique stock picking approach. While a firm advocate of the principles of value investing, he believes in adapting a versatile investing strategy in response to varying market conditions. Devanshu contributes to our Megatrend investing service The India Letter.

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