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Stock Strategist

Get in Touch with Your Private-Equity Side

Underleveraged company value is often underappreciated by individual investors.

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Many investors who have watched the slew of private-equity deals undertaken over the past couple of years might say to themselves, "What are these guys thinking? How can you make money buying companies for premiums?" While bids can certainly be opportunistic as companies trade near unreasonable or cyclical lows, there is also a very straightforward, simple principle that is also often times at work--debt is usually cheaper than equity, a disparity that can become particularly large for companies that generate strong, regular cash flows and use very little leverage. While debt requires regular interest payments, equity holders require a higher rate of return due to their subordinated claim to a company's assets, a less rigid or defined payback structure, and the higher risk of the asset class. This simple truth can have powerful consequences.

Though some industries such as drug development or technology have inherent risks that might make taking on additional debt prohibitively risky or expensive for early- or investment-stage companies, there are a number of mature firms with stable cash flows in these and other industries that I think could unlock value with more leverage, even very large companies that are unlikely to be the targets of a leveraged buyout. In most cases I am envisioning debt potentially being used to buyback a significant chunk of equity, though other capital allocation decisions such as boosting dividends can have similar effects. This analysis assumes that the company's stock is trading below our fair value estimate in the case of share buybacks. I am admittedly grossly oversimplifying the situation in order to make the point that chronically inefficient capital structures can depress a company's valuation. Conversely, underleveraged balance sheets can also provide a somewhat hidden means of appreciation if and when the structure is changed.

Matthew Reilly does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.