How does financial leverage affect stock returns?

Last week, we discussed in this column “How does operating leverage affect stock returns?” that one source of business risk is the amount of company’s fixed costs relative to its total costs.

When a company has a high fixed cost, it means its operating profits are more sensitive to changes in sales, which makes its stock risky, especially during times of economic recession.

Now, when a company borrows money to finance its assets, the interest expense that it incurs is also a source of business risk. Interest expenses are financial charges that are deducted from operating profits to derive a company’s net profit.

If a company has a high interest expense, it must generate enough operating profits to make a good return on its investments; otherwise it will incur losses even if the business is commercially viable.

Like in operating leverage, interest expenses are fixed costs too. When a company has covered its interest expenses, any small increase in operating profits can magnify its net profit.

This is good when business is growing but when times are bad, a highly leveraged company can face significant financial distress because any decline in operating profits can result in substantial losses.

Such sensitivity of net profit to changes in operating profits is what we call the degree of financial leverage (DFL). Similar to DOL, a high DFL, as an indicator of risk, can lead to lower share price valuations.

If we look at how Price-to-Earnings (PE) valuations of PSE index stocks relate to their respective DFLs, we can see that those with P100 billion market capitalization and above have strong negative correlation at 39 percent.

This means that large-cap stocks tend to be valued by the market with lower PE ratios as their DFLs increase.

For example, Ayala Corp, which has high DFL of 13.9, has a PE ratio of only 6.2 times as compared to SM Investments, which has a low DFL of 0.94 but enjoys a high PE ratio of 21.9 times.

We know that the DFL is a product of a company’s capital structure, which is measured by its debt-to-equity ratio. Changes in debt-to-equity ratios can affect stock returns through changes in DFL levels.

If we add the debt-to-equity ratio along with DFL as determinants of a stock’s PE ratio, we will find that the negative correlation is further strengthened to 51.9 percent.

Given this historical correlation and expected contraction in the economy, we can say that large-cap stocks with the highest DFLs are the ones that will suffer the most.

It is interesting to note that stocks with high DFLs cannot have high DOLs at the same time and vice versa because every company can only assume a certain level of business risk.

For example, if a company is considering investing heavily in capital expenditures but wishes to achieve a desired target risk, it can choose to lower its DFL by issuing shares instead borrowing in order to balance its risks from higher DOL.

Last year, the business risk of the market was geared more toward financing rather than operating because the median DFL of PSE Index stocks of 0.46 was higher than its DOL at 0.16.

If we multiply the DFL with DOL, we will find that the total business risk of the market at that time was 0.09. This year, this risk level has remained the same, only that the composition has changed with the market increasing its operating risks with DOL at 0.65 while lowering DFL to 0.34.

As economic uncertainty rises, we can expect the desired level of business risk to go down as companies undergo cost and capital restructurings in the future.

Lower DFL and DOL may reduce losses later but may also mean smaller expected returns, hence lower stock prices.

In times like this, understanding leverages like DFL can be a useful tool in determining the financial health and strength of a company by assessing its potential risks and profitability. INQ

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend 83rd batch of RFP Program this June 2020. To register, e-mail [email protected] or text at 0917-9689774