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Author: sleejohnson Three stars, 500 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 197  
Subject: Re: Q2 Results Date: 8/10/2001 10:10 PM
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I have a question: You say that KARE is worth a P/E of 8 to 10. I wonder if you are giving due consideration to their level of debt? Right now they have about $6 / share in debt!

Another way of putting it: If KARE had $0 in debt, would you value them at $8.24 to $10.10 per share?


No. A reduction in a company's debt does not necessariliy translate dollar for dollar into an increase in market cap. In KARE's situation, I was using P/E as a valuation tool basically as a surrogate for future free cash flows. I did not do a DCF analysis becuase I have too much uncertainty regarding the future cash flows.

In some cases, debt can be good, at least if the company is able to invest the proceeds in something that gives a better return than the interest they pay. Still, it is usually better to have little or no debt.

For example, consider Comapny A, which has 100 shares selling at $1 each ($100 market cap) and coincidentlally has a book value (equity) of $100. Let's say Comapny A earns $15/year net profits for a return on equity of 15% and a p/e ratio of 6.67. Now, let's say company A borrows $100 as long term debt at 10% interest and uses the proceeds to buy $100 of assets. Let's say these new assets also give a return of 15%. Comapny will now earn $30 before interest and $20 after interest. ROE is now 20$ and EPS is $0.20. Which is worth more, Company A with no debt and $0.15 EPS or Comapny A with a debt to equity ratio of 1 and $0.20 EPS? The former is less risky, but the latter offers better prospects if nothing goes wrong.

I accounted for the debt level by adjusting the P/E. If KARE had no debt, I might be inclined to give it a P/E of 10 or 12. KARE's debt is fairly high, however. It might look like a debt to equitiy ratio of about 1, but if you subtract out goodwill and intangible assets, you'e find the debt to "tangible equity" (not a real term), the ratio is more like 3. So if you wanted to adjust the P/E down to 5 or 6 because of the debt and the risk that they won't be able to renegotiate the credit facility on favorable terms, I won't argue with you.

Slee

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