Buying debt increases the value of equity

We discussed yesterday the rumoured possibility that the ECB may buy corporate bonds, this story has subsequently been featured in many of Wednesday's papers. We also said that should this be true it could materially benefit equity prices, and we thought it may be worth explaining in a simple way why.

Benjamin Graham, considered the father of investment and Warren Buffett’s mentor devised a simple method for determining the potential equity value of a company. Graham's formula calculates the value of a company by taking a price/earnings ratio and multiplying it by a growth rate of one's choosing, taking that result and multiplying that by 4.4%, (AAA corporate bond rate when he devised the formula) and dividing the answer by the prevailing 20-year AAA corporate bond yield. 

If a company has an EPS of 10p per share and you put a market p/e of 13x and assume a growth rate of 1.5.

10p (13x 1.5) x 4.4 / 20 year AAA corporate bond yield = value per share of the equity. If in this case one uses 5% for the corporate bond yield the value of the equity is 167 pence per share. If one were to replace the prevailing bond yield with 4% the value of the equity would rise above 200p. So one can see how reducing the cost of debt increases the value of the equity. 
European corporate debt prices have risen in the past few days, Greek 10-year bond yields have fallen back towards 7.5% today, so at present without doing a great deal it appears Mario Draghi has once again brought calm to capital markets.

 

Posted on October 23, 2014 .