Watch the video with Andrew Stotz on the amount of debt in the long-term capital structure when forecasting a company or read a summary below.
The amount of debt in the long-term capital structure
How much debt will a company carry in the long-term?
This discussion starts by accumulating the financial statements of the 500 largest and most liquid non-financial companies in Asia.
What would happen to the WACC if debt was 30%, 40%, 50%, or 60% of total capital?
Debt component of capital fluctuates based on the market value of equity
Assume that the debt level of a company remains the same throughout the stock market’s ups and downs. Also, assume that the book value of equity is the same over the same period. The only thing that will change is the price-to-book ratio. When it is low the market is pessimistic, when it is high the market is optimistic.
If the value of equity of a company is trading at a low 0.5x price-to-book value then the debt will appear as a large portion of capital. If the value of equity is trading at an expensive 4.0x then debt appears tiny. But debt never changed.
Forecast long-term debt between 0% and 50%
- When forecasting the long-term portion of debt as a % of total capital consider a range from 0% to 50%
- If you estimate over 50% you are saying that from now to infinity the lenders to the company will put in more capital than the equity holders, this is unlikely
- In addition, such a forecast will cause your WACC to be very small, producing a high valuation of the stock
- Also, be aware of the price-to-book value of the company’s stocks
- If it is trading at a very high 4x multiple the debt level may appear small
- This would produce a higher than realistic WACC, hence a lower than realistic value for the stock
- A price-to-book value of about 2x might be more realistic
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