The Value of Deleveraging – A Paradox

February 8, 2011

Future economic historians may refer to the period beginning in 2009 and continuing for some years into the future as the era of deleveraging, at least for everyone except the U.S. government. I have often voiced the opinion on this site that companies that are in compliance with the times by voluntarily paying down debt early are an attractive prospect. This has informed my recommendations of Belo Corporation, Entercom, and even Chiquita Brands. However, as with many things in the stock market, the benefit of deleveraging depends on the valuation model we use. A good review of equity valuation models is contained in Damodaran’s useful toolkit, Damodaran on Valuation. Although value investing adds certain nuances based on stability of cash flows, credit quality, and other qualitative factors, a basic knowledge of valuation according to orthodox practice cannot fail to be useful to value investors, even if only for the reason that other market participants use it.

The simplest method of valuation is the dividend discount model, where the future dividends of a company are discounted to a present value based on whatever required return on equity the investor chooses. Although this method does rightly focus people’s minds on cash returns, this method has several defects. First, it requires investors to project the future course of dividend payments, and investors are perennially incapable of seeing into the future. Second, particularly in the current era of low dividend yields, it often transpires that even a mature company does not pay out anywhere near as much in dividends as it can.

This led to the modern approach of valuing companies based on free cash flow yields. Free cash flow, of course, is the money that a company can afford to pay out of its cash flow after making due provision for maintaining its earnings power. The logic behind the use of free cash flow analysis is that a company is valued based on its potential dividends rather than its actual dividends, and moves us closer to the concept of profit in the economic sense.

However, the confluence of the two models often creates paradoxical results. I will demonstrate this paradox by simplifying the numbers and capital structure of Belo Corp. The company is capitalized with about $1 billion of debt at a yield of 7%, and produces $70 million a year in free cash flow. If we allow that a 10x multiple is a reasonably conservative valuation, we would expect the equity of the company to be worth $700 million. However, the company, although its debt situation is reasonably stable and sustainable, chooses to devote all of its free cash flow to paying down debt

A year later the company would save itself $5 million in interest, which comes to about $3 million after taxes. If we keep the multiple at its conservative level, we will find that the value for the new company becomes $730 million dollars. The paradox lies in that we have clearly earned $70 million dollars in free cash flow over the year and should be $70 million better off, but we have a company at the end of the year that has no more cash than it did at the beginning of the year and is worth only $30 million more.

Now, even Damodaran, although he does not go into great detail, acknowledges that free cash flow does not include debt repayments , but logically, how can this cash flow not be “free” when management could simply roll their debts over as they fall due and keep the money.Even so, management’s decision to pay down debt does move us back into the more primitive world of dividend discounts, because using the money to buy back debt is the equivalent of canceling a dividend for that year, so the view that $30 million, rather than $70 million, is our “true” earnings may be have some logical support. And applying the dividend discount model consistently, we can conclude that $730 million is the correct value only if management decides not to pay down debt next year, and it just as naturally follows that $700 million was the correct value only if management decided not pay down debt this year.

This puts the dividend-discount investor in the always-uncomfortable position of trying to see in the future, and guessing at what point the capricious opinion of management will decide that a given amount of debt paid down is enough, calculating the free cash flow value on that date, and discounting that figure to present value. As investors are, again, incapable of predicting the future accurately, this makes these companies very difficult to identify as inexpensive.

Free cash flow is meant to calculate an investor’s returns on an economic basis, but the trouble is that the company is using the money that is required to produce here a 10% return on an investment in order to effectively “invest” in the company’s own debts, which action here produces a return of 4.2% on an after-tax basis, rather than giving the money to the shareholders or at least keeping it for their potential future benefit, to allow them to seek higher returns on their own. This difference between 4.2% and 10% is presumably where the missing $40 million went. True, shareholder equity increases by the full $70 million, the liquidation value of the equity is improved by the full $70 million, but on a going-concern basis the liquidation event is assumed to occur many years in the indefinite future—and in fact, the paying down of debt may be exactly what pushes the liquidation date out further. I do not know the resolution to this situation.

If conservativeness in valuation methods means anything, it counsels us to use the lower calculated value whenever there is one, particularly if the decisions of management are viewed as forcing shareholders to invest in the company’s debts. And yet, the efficacy of free cash flow analysis has a long pedigree, and it may be that the company derives benefits from paying down debt in terms of the diminished perceptions in the market of the possibility of financial distress. Of course, prudent value investors assure themselves first of all that financial distress is highly unlikely, but the broader market may take more convincing, and there may be a multiple expansion that could be attractive to the more trader-oriented types. As it stands, though, I can only conclude that companies that are deleveraging ought to be held to a more stringent than normal standard for what constitutes a compellingly low valuation.

One Response to “The Value of Deleveraging – A Paradox”

  1. My feeling is that this is not really a paradox. I’m willing to pay a higher multiple for a company that is less leveraged. Shaving off debt clearly reduces the risk of a company and therefore the cost of equity.

Leave a Reply