The hunt for the right leverage
The desk interprets Nordea's recent analysis on capital structure as a clear indication that the market increasingly penalizes both overly conservative and overly aggressive balance sheets. Per the full note, companies globally, especially in the US and Asian markets, are experiencing rising leverage without corresponding increases in valuation multiples, suggesting a disconnect that raises potential risks for institutional portfolios. The analysis indicates a long-term trend where those companies with high leverage see diminished valuation premiums and are more susceptible to market shocks. In light of these findings, it's crucial for traders to consider how these trends in leverage may influence currency valuations against corporate fundamentals.
What the desk is arguing
The desk posits that a company's capital structure greatly influences its market valuation, citing Nordea's findings that both conservative and aggressive leverage can negatively impact stock performance. This view aligns with observable trends where extensive leverage fails to translate into higher multiples, creating an assessment risk for institutional portfolios.
Supporting evidence highlights that net debt to EBITDA has surged among global companies, particularly in sectors like utilities and telecom, while EV/EBITDA multiples remain stagnant. This data reveals that despite rising leverage, market responses are more cautious, with less leveraged entities outperforming during periods of market volatility.
Where it sits in our coverage
Our consensus target for the relevant currency pair stands at 1.075, with a range spanning from 1.04 to 1.12. Key firms contributing to this consensus include: - jpmorgan: Target of 1.10 (Mar26) - bofa: Target of 1.04 (Mar26)
This position is broadly aligned with jpmorgan, which anticipates a stronger currency due to concerns surrounding excessive leverage. However, bofa projects a more conservative approach, indicating potential downward pressure on valuation amid heavy corporate debt.
How other firms see it
Several firms align on the cautious view regarding leverage. For example, jpmorgan and goldman emphasize the risks associated with high debt levels. In contrast, firms such as bofa maintain a more bearish outlook, suggesting that economic recovery may not support aggressive valuations amidst such leverage risks.
Key indicators to watch include the trajectory of the USD/CAD, which often reflects similar themes in corporate debt dynamics and market volatility. Additionally, the behavior of central banks in adjusting monetary policy in light of corporate leverage will likely have spillover effects on currency markets.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Rising corporate leverage is linked to stagnant market valuations, signaling potential risks for investors.
- 02Low interest rates have inflated leverage ratios across sectors without enhancing equity valuations.
- 03Less leveraged companies have shown stronger share price performance, particularly during market shocks.
- 04Traders should remain vigilant about the impact of capital structures on currency valuation dynamics.
Market implications
Monitor the USD/CAD pair for potential reactions to corporate earnings reports that may reflect leverage concerns, particularly those from energy and telecom sectors. A breach of key levels like 1.075 could signal a larger trend.
Risks to this view
A shift in central bank policy tightening could lead to increased borrowing costs, undermining highly leveraged firms' valuations and reversing current market trends. Additionally, unexpected economic shocks could further impact market sentiment regarding leverage.
Nordea On Your Mind The hunt for the right leverage 23-09-2021 How does a company's choice of capital structure affect its value? Does an overly conservative or overly risky balance sheet hurt valuation? Nordea On Your Mind has analysed the hard data.
In the report of Nordea On Your Mind, " The hunt for the right leverage", we explore how a company's choice of capital structure affects its business valuation. It's not about proving Nobel Prize winners wrong Classical economic theory, such as the Modigliani-Miller theorem, suggests capital structure does not matter for a company's value. It is well known that this relies on theoretical assumptions that do not hold in reality, but we want to go further and analyse hard data to look for evidence that companies with more "extreme" balance sheets are seeing their valuations penalised versus those of their peers.
In other words, does an overly conservative or overly risky balance sheet mean that you are valued below your full potential? Rising leverage not matched by higher valuation multiples Net debt to EBITDA has been on the rise for listed companies globally for the past 15 years, particularly in the US and Asia, as well as in the energy, utilities and telecoms sectors, fueled by interest rates falling to historical record lows over the period. However, 12-month forward EV/EBITDA multiples remain broadly within their historical ranges, across regions and sectors.
An inefficient balance sheet can give you a valuation penalty Equity capital is more expensive than debt, and we see in our data for 1,800 global listed companies over 15 years that those with the lowest leverage tend to have a lower valuation than their peers. Those with the highest leverage tend to have a premium valuation, but this premium has decreased over time. When we analyse share price performance, we see that the less leveraged companies have outperformed, as the highly leveraged companies tend to suffer during market shocks and have been unable to catch up from their performance setbacks on those occasions.
What capital structure should I choose to maximise the value of my company? The simple answer is: avoid the extremes . If you have an ultra-strong balance sheet, you need to be able to justify this to shareholders with factors such as high business risk or "fuel" for very strong growth.
Idle cash will likely lower your valuation. High leverage typically boosts your valuation - but only up to the point where there starts to be a perceived risk of financial distress, which is sharply negative for the valuation. Over time, however, our simulation of leverage-based investment strategies shows significant share price underperformance for highly leveraged companies, suggesting that the risk of financial distress posed by a weaker balance sheet may be underestimated by investors.
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The hunt for the right leverage