Leverage ratio of your portfolio

[beerbaron]

I did an unorthodox calculations today on my portfolio based on the logic that the balance sheet structure of a company makes no difference.

 

For example two companies A & B, have the same sales and ROA. A has 100% debt to equity and B has 0%. We would expect A to have double the ROE but it should not trade at a premium because the investor buying B could use margins at 2x1 and get the equivalent return then A.

 

(Assuming no taxes and equivalent financing costs)

 

So I wanted to know what's my leverage ratio based on the weighted Debt/Equity (leverage) of all companies I earn. I believe it would give a good estimate of the bankruptcy risk of my portfolio. In the end I ended up with an indirect leverage of 1.4 to 1 which I consider really low given that a fair amount of my stocks (30%) are financial.

 

Did anybody else use this kind of calculation to evaluate the bankruptcy risk of your portfolio?

 

BeerBaron

[Packer16]

Another way to do is to look at the ratings of issued bonds and apply the historcial defalut of bonds of that rating.  I have adjusted my fair value targets when I buy a leveraged firm's equity in this way.

 

Packer

[twacowfca]

I did an unorthodox calculations today on my portfolio based on the logic that the balance sheet structure of a company makes no difference.

 

For example two companies A & B, have the same sales and ROA. A has 100% debt to equity and B has 0%. We would expect A to have double the ROE but it should not trade at a premium because the investor buying B could use margins at 2x1 and get the equivalent return then A.

 

(Assuming no taxes and equivalent financing costs)

 

So I wanted to know what's my leverage ratio based on the weighted Debt/Equity (leverage) of all companies I earn. I believe it would give a good estimate of the bankruptcy risk of my portfolio. In the end I ended up with an indirect leverage of 1.4 to 1 which I consider really low given that a fair amount of my stocks (30%) are financial.

 

Did anybody else use this kind of calculation to evaluate the bankruptcy risk of your portfolio?

 

BeerBaron

 

Yes, informally.  LRE's debt is about 8% of their capital with no restrictive covenants and very long term.  BRK's is also low, but not quite so low considering subsidiary debt.  FFH's is higher, but they have large hedges. :)

[Guest Hester]

For example two companies A & B, have the same sales and ROA. A has 100% debt to equity and B has 0%. We would expect A to have double the ROE but it should not trade at a premium because the investor buying B could use margins at 2x1 and get the equivalent return then A.

 

Wouldn't the fact that margin debt is fully recourse to your other assets while a company's debt that you own stock in is not, make the two not analogous?

[Packer16]

Another advantage is taxes.  The 100% equity financed firm gives up the gov't tax shield so it should sell at a premium if it is in a stable indsutry.

 

Packer

[beerbaron]

I'm not the one that wrote the theory! I believe it's some kind of quantz that won the Nobel price (don't remember, Samuelson maybe?). Of course taxes are a modifier and the fact that it's non-recourse add some kind of extra shield to the stockholder.

 

But I was trying to asses is the leverage ratio of people's portfolio in terms of their holding, not in terms of their brokerage account. A portfolio based on highly leveraged stocks is pretty much the same as leveraging your brokerage account. You are indirectly adding bankruptcy risk or having a zero. Yet people totally forget both are somewhat linked.

 

Taleb has said during it's last interview that banks did not make any money in the last 30 years, which I somewhat agree. But the leverage ratio has something to do with it. ROE of banks are impressive in good time but so bad in bad times.

 

BeerBaron

[Packer16]

You are correct and Damodaran has a good concept that I have applied.  I believe if you go to his site you can see the details under valuation of highly levered or distressed firms.  The concept for common stock is to make an adjustment to value by including a default scenario where the value is zero and the probabilty is based upon the credit rating of the debt.

 

Packer