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High debt companies may not be able to survive the slowdown

The stock market always offers opportunities, more so during volatile times like these. However, investors who bet on wrong opportunities can get into trouble.

You often hear comments like: “The share price has already reached this level, how much lower can it go?” Such statements usually refer to stock prices that are falling freely. For instance, Reliance Communications is quoting at 80 paise at present. However, comparing past and present share prices is an erroneous way of looking for opportunities.

Another mistake is betting on market capitalisation. For example, Vodafone Idea’s market cap is only Rs 14,396 crore, while Tata Motors’ market capitalisation is only Rs 33,594 crore. It might appear very cheap because the general perception is that these global giants deserve higher valuations.

However, a look at their total debt reveals a different story. The total debts of Vodafone Idea and Tata Motors as on 31 March 2019 were Rs 1,08,524 crore and Rs 91,124 crore respectively. This implies that their total debt is much higher than their market capitalisation. This does not mean that one should avoid all stocks with high debt, but there is a need to be cautious, keeping in mind the current slowdown. “Companies with heavy debt can get into trouble if the situation worsens,” says Atul Kumar, Head – Equity Funds, Quantum Mutual Fund.

High debt is bad news in a slowdown
Companies with heavy debts may not be able to stay afloat in a slump.
*All the figures have been rounded off

Cash-rich companies will sail through slump
Cash-rich companies are better equiped to handle a slowdown.
Compiled by ETIG Database

Use enterprise value
While market capitalisation is stated to be the total value of a firm as assessed by the market, it is only partly accurate. Enterprise value can be defined as market capitalisation+debt– total cash and cash equivalents.

What is the logic behind considering debt and cash? This is because if someone buys the all the shares or market cap of a company as a going concern, the buyer will also be liable to pay off the entire debt. Besides, the new buyer will have access to the entire cash on books and the same can be used to pay off the debt. With the introduction of debt and cash in computation, the enterprise value of a cash-rich company—where there is more cash than debt—will be less than that of its market capitalisation. Theoretically, enterprise value can even be negative if the cash on books is more than the market capitalisation of the company.

EV/sales ratio
Market cap/sales ratio is commonly used to value a company, usually when the camparisons are among the companies in the same industry. It is relevant for both cash rich or low debt companies. However, it becomes irrelevant for companies with high debt and therefore, we need to use enterprise value/sales ratio. For example, market cap/sales ratio is just 3.32 times for Adani Green Energy, but its enterprise value/sales ratio is at 8.56 times.

We compare net profit and shareholders’ funds to find out whether a company is generating enough money for its shareholders or not. Similarly, the enterprise value is compared with Ebitda to know whether the business is generating enough money. The interest costs, etc is not considered because the debt is also part of enterprise value. “Enterprise value/Ebitda will give a clear picture whether the company can service its future obligations,” says Kumar.

While using these ratios, investors should be careful about industry dynamics. For example, both the top scorers on EV/Ebitda score, HEG Ltd and Graphite India, are from the electrodes industry. Despite reporting heavy profits, valuations are low because of the industry turnaround and possible fall in future profits.

This is used to assess companies where enterprise value is higher than market cap. The normal ratio used for such companies is interest coverage ratio— to find out whether the company is making enough cash to pay its interest burden. So what is the advantage of debt/Ebitda ratio? “Interest cover ratio only tells us about the company’s ability to pay interests. Debt/Ebitda ratio tells us about its ability to pay principal also. Investors should take extra care if this ratio is above three,” says Sandeep Nanda, CIO of Bharti Axa Life Insurance.
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