Interview question

Just recently interviewed with a HF and i was asked a P/E question that caught me off guard for a little bit and was curious to see how fellow L2’ers would respond. If we had two companies (a & b) in the same industry and A had a P/E of 6 and B had a P/E of 10 which has the higher debt?

B has higher debt— If both have PPS=100 then eps of A = 16.67 and for B=10 which means NI of A > NI of B - which means B has higher interest expense than A all else equal. so B has higher debt although I am not sure if this logic makes sense. did they tell you the answer?

Based on how the question is worded, where it is not said if sales/margins/etc are equal, you can’t say for sure. One way I would look at it would be a generalization that B may have a higher growth rate, giving it a higher P/E, and generally more debt to support that growth. On the other hand, B could have no debt, and trade at a higer P/E comparitively because A has too much debt, and maybe a bankruptcy issue. Or, they could both have the same sales, and B uses debt wisely with the tax shield, and creates more value through that tax shield for equity holders, and in return a higher P/E. The P/E ratio doesn’t tell you a whole lot about the financing of a company. But I hate these kinds of questions…and I may be incorrect, without some paper to write things out. haha

you are right - there has to be some assumptions made so i assumed everything else equal- same industry, same operating characteristics etc. I think the interviewers pay more attention to your logic and thought process than a black and white answer.

Clearly you cannot tell which company has the higher debt simply from the P/E ratio. It’s possible that the market would favour or shun higher debt depending on sentiment, etc - if leverage is avoided, then A has higher debt, if the reverse then vice-versa. There is an argument to make, spurious but I’ll make it all the same, since it’s probably the smart arse answer (unless the idea is just to watch how you reason, and there’s no real answer - v likely): If financial leverage is sought, investors can easily themselves create that condition by leveraging their shares themselves. The reverse being true as well (investors can borrow to deleverage by buying guilts), financial leverage should not in a simplistic and efficient market create or destroy value (Modigliani-Miller). However, at some point financial leverage becomes more than a mere magnifier of earnings - it becomes an operational liability, as business partners and consumers grow wary of you and your future as a going concern is under threat. Therefore, all things being equal, financial leverage can only be neutral or negative for companies’ market values. Therefore, company A with the lower P/E is the debt junkie. Again, this is nonsense for all sorts of reasons - for example, earnings can be of varying quality (including exceptional items), companies can be differently diversified and positioned within the same industries, etc, etc. But either there’s no answer or it’s A, I reckon.

A => increased debt = increased risk = increased required rate of return = decreased p/e im with lmb on this one

Erratum: Just read back by my post and spotted a slip (accidental, not conceptual in origin, I assure you!). Paragraph 4 in parentheses - replace “investors can borrow to deleverage” with “investors can lend to deleverage”).

I would pick B, but A can be true also

Isn’t it as simple as - if B has a higher PE ratio, higher growth is expected, and this company is probably in an earlier stage than A - less leverage. A may be a mature company with lower growth expectations, and would probably have much more debt financing.

I’d pick A because the market is pricing same earnings value at a lower price . The leverage A is using is higher , ergo it has higher debt for same level of equity

I’m rusty on this, but seems like this is getting at Modigliani/Miller idea of debt vs equity (which is what others here are also saying). Probably if you give an answer along those lines it would be OK for interview purposes.

MM say , in a perfect world , Debt and Equity don’t matter as a choice , one can use either in a firm , with no adverse impact to the value of the firm as a whole So how is MM going to drive a choice between High P/E and Low P/E ? the E part of P/E would be priced the same regardless of debt ?

Right, MM says value of the firm doesn’t change, but it doesn’t say the return to equity (or debt) is invariant to D/E ratio. Maybe the chart here helps? As you increase D/E the return to equity increases (as does the return to debt) as the firm becomes more internally leveraged. The invariance of MM is not about the P/E not changing but rather that you can end up with an equivalent result with internal leverage (firm issuing more bonds) or with investors buying on margin. Meh, this may not be the most obvious way to approach the problem but just popped into my head. For what it’s worth.