The indebtedness of a company is one of the factors that we must analyze in our valuation process. It is not a trivial issue, since the value of a company can vary considerably depending on its level of indebtedness. In addition, the accuracy of our valuation can decrease significantly in the case of heavily indebted companies.
In this article we will see why it is almost impossible to accurately value heavily indebted companies with a real example, the valuation of the Spanish construction company Sacyr.
Real example of valuation of a highly indebted company
As you already know, the followers of value investing We look for companies that are listed below their intrinsic value and offer a safety marginenough. The weight of the investment decision will therefore fall on the valuation that we have obtained after analyzing the company.
About 3 months ago, Garci, a good friend and value investor, told me about the idea of investing in the construction company Sacyr. I'm not going to go into the company valuation process, as I don't want to focus on it. Furthermore, the analysis needs to be updated, as Sacyr has just announced scenario analysis. Below we will see two additional scenarios, one more optimistic and the other more pessimistic.
Sacyr valuation: Optimistic scenario
In this scenario, I assume that the value of the businesses calculated by my friend Garci is 20% higher than in the main scenario.
In this scenario, the value of the businesses would be 10.146,6 million euros. As the debt would remain constant, the net value of the company would be 3.809,6 million euros. Therefore, the intrinsic value per share would be € 6,98 per share. In other words, the intrinsic value would grow by almost 80%.
Sacyr's assessment: Pessimistic scenario
In this case, we are going to assume that Garci has been optimistic in his calculations and that Sacyr's businesses are worth 20% less than what he has calculated.
In this case, the value of the businesses would be reduced to 6.764,40 million euros. As the debt does not change, the net value would be reduced to just € 427,40 million, which would mean an intrinsic value per share of € 0,78. In this case, we see an 80% drop in the value of the company.
The almost impossible mission of valuing heavily indebted companies
As you have seen, a small difference in the value of the businesses of a heavily indebted company can lead to a large variation in the intrinsic value of its shares.
In the following table we can see the summary of the 3 scenarios analyzed in Sacyr's valuation.
Sacyr scenario analysis
Debt is not just a problem for the company. It is also a problem for investors to obtain intrinsic value with adequate precision.
It is much more difficult to accurately value indebted companies such as Sacyr than others with little debt, since small changes in the estimates or in the scenarios cause large changes in the intrinsic value that we have calculated.
Don't forget rule # 1
We must not forget what Warren Buffet never tires of repeating:
"Rule number 1 is not to lose money"
To which he always adds:
"Rule number 2 is to never forget rule number 1"
Many of us ignore this rule, but it ends up taking its toll.
Should we completely avoid indebted companies?
Investing in indebted companies is not usually highly recommended, so I do not recommend, in principle, investing in them.
As you have seen, debt is not only a problem for companies, it is also a problem for investors, since accurately valuing highly indebted companies is an almost impossible mission.
My personal decision is to try to avoid them or, in the case of investing in them, to look for a very wide margin of safety that makes the potential return on the investment more than outweigh the risk of violating rule # 1.
Now it's up to you
Do you invest in indebted companies?
Does Sacyr seem like a good investment at current prices?
I await your comments!