In the report of Nordea On Your Mind, "The hunt for the right leverage", we explore how a company's choice of capital structure affects its business valuation.
It's not about proving Nobel Prize winners wrong
Classical economic theory, such as the Modigliani-Miller theorem, suggests capital structure does not matter for a company's value. It is well known that this relies on theoretical assumptions that do not hold in reality, but we want to go further and analyse hard data to look for evidence that companies with more "extreme" balance sheets are seeing their valuations penalised versus those of their peers. In other words, does an overly conservative or overly risky balance sheet mean that you are valued below your full potential?
Rising leverage not matched by higher valuation multiples
Net debt to EBITDA has been on the rise for listed companies globally for the past 15 years, particularly in the US and Asia, as well as in the energy, utilities and telecoms sectors, fueled by interest rates falling to historical record lows over the period. However, 12-month forward EV/EBITDA multiples remain broadly within their historical ranges, across regions and sectors.
An inefficient balance sheet can give you a valuation penalty
Equity capital is more expensive than debt, and we see in our data for 1,800 global listed companies over 15 years that those with the lowest leverage tend to have a lower valuation than their peers. Those with the highest leverage tend to have a premium valuation, but this premium has decreased over time. When we analyse share price performance, we see that the less leveraged companies have outperformed, as the highly leveraged companies tend to suffer during market shocks and have been unable to catch up from their performance setbacks on those occasions.
What capital structure should I choose to maximise the value of my company?
The simple answer is: avoid the extremes. If you have an ultra-strong balance sheet, you need to be able to justify this to shareholders with factors such as high business risk or "fuel" for very strong growth. Idle cash will likely lower your valuation. High leverage typically boosts your valuation - but only up to the point where there starts to be a perceived risk of financial distress, which is sharply negative for the valuation. Over time, however, our simulation of leverage-based investment strategies shows significant share price underperformance for highly leveraged companies, suggesting that the risk of financial distress posed by a weaker balance sheet may be underestimated by investors.
Views from the proactive pioneers
We have interviewed CEO Lars Dahlgren and CFO Anders Larsson from Swedish Match, which has largely stuck to a clear and transparent financial policy from 2005 and has consistently used share buybacks to avoid accumulating idle cash. In another interview, Kongsberg CFO Gyrid Skalleberg Ingergø describes how a major acquisition became a catalyst for a journey towards an optimal capital structure, which has involved bonds, dividends, share buybacks and a rights issue.
