O'Reilly logo

Valuation: Measuring and Managing the Value of Companies, Fifth Edition by Marc Goedhart, Tim Koller, McKinsey & Company, David Wessels

Stay ahead with the world's most comprehensive technology and business learning platform.

With Safari, you learn the way you learn best. Get unlimited access to videos, live online training, learning paths, books, tutorials, and more.

Start Free Trial

No credit card required

APPENDIX E
Leverage and the Price-to-Earnings Multiple
This appendix demonstrates that the price-to-earnings (P/E) ratio of a levered company depends on its unlevered (all-equity) P/E, its cost of debt, and its debt-to-value ratio. When the unlevered P/E is less than 1/kd (where kd equals the cost of debt), the P/E falls as leverage rises. Conversely, when the unlevered P/E is greater than 1/kd, the P/E ratio rises with increased leverage.
In this proof, we assume the company faces no taxes and no distress costs. We do this to avoid modeling the complex relationship between capital structure and enterprise value. Instead, our goal is to show that there is a systematic relationship between the debt-to-value ratio and the P/E.

STEP 1

To determine the relationship between P/E and leverage, we start by defining the unlevered P/E (PEu). When a company is entirely financed with equity, its enterprise value equals its equity value, and its net operating profit less adjusted taxes (NOPLAT) equals its net income:
581
where
VENT = enterprise value NOPLATt+1 = net operating profit less adjusted taxes in year t + 1
This equation can be rearranged to solve for the enterprise value, which we will use in the next step:
582

STEP 2

For a company partially financed with debt, net income (NI) equals ...

With Safari, you learn the way you learn best. Get unlimited access to videos, live online training, learning paths, books, interactive tutorials, and more.

Start Free Trial

No credit card required