In book seven 2am, Q40, it says that when using the P/S technique, “it is important that the analyst be aware of each comparable’s capital structure.” How does the capital structure play into the formula? There was no interest number given, only debt/capital. I see that this company has more debt than the others, but what are you supposed to do, just adjust the P/S ratio arbitrarily? Thoughts welcome Thanx
Well P/S is [PM x (1-b) x (1+g)] / (r-g) so with a capital structure with higher amounts of debt you will see a lower Profit margin due to interest expense… this should then lower P/S…
I don’t think there is a specific adjustment that was suggested in Schwesser. However, I would think since the net profit margin is used in the calculation you could compare a levered firm to an unlevered firm by removing the effect of interest expense. The equity cost of capital and the growth rate could also be adjusted I suppose. For instance the ROE which determines the growth rate would be affected by financial leverage. I think the key point in Schwesser however is that you should generally use P/S to compare companies with similar levels of leverage. If they are not similar then using the P/S may not be appropriate without adjustments.