The Levered P/E Ratio

Abstract

A vast literature examines the role of debt in corporate valuation, but most of these works proceed from the vantage point of corporate finance (i.e., ascertaining the effects of adding debt to a previously unlevered company). The investment analyst, however, confronts an already-levered company with already-levered return parameters. The analyst's challenge is to estimate the stock's theoretical value by inferring the company's underlying structure of returns. This shift in vantage point leads to results about the effect of leverage that are surprisingly different from the results of studies from the corporate finance angle. Whereas corporate finance studies find only a moderate effect of leverage, when viewed from the analyst's perspective, a company's value has such a high degree of sensitivity to the leverage ratio that it can significantly alter the theoretical P/E valuation. Moreover, from the analyst's vantage point, leverage always moves the P/E toward a lower value than that obtained from the standard formula.