Tuesday, June 26, 2007

If you were to rescue her the reward would be...

Apparently Home Depot's risk dial goes to 11, and the plan as sparked quite a discussion on whether financial engineering really creates shareholder value. Here is how I come out on it.

Investors have different risk tolerances. Some are happy to own a portfolio of Treasury bonds, or high-quality municipals, and nothing else. In essence, these investors are just looking to keep up with inflation.

But most investors need more. They need to see their portfolios grow in order to meet whatever needs they have. This is the primary reason to own stocks. Stocks carry considerably more risk of loss compared with high-quality bonds, but also have substantially higher expected return.

I believe it is therefore possible for a company to not carry enough risk. Or more to the point, not take enough risk to earn the kind of return I need to consider owning it.

Now, I don't follow Home Depot's stock closely enough to make a professional opinion on whether that is the case. So let's deal in hypotheticals. Let's say that ABC corp is currently earning a very consistent ROE of 7% with no leverage. Let's also say that the chance of bankruptcy over 10-years 2% (about equal to the historical figure for a Aa-rated company). So to make it simple math, there is a 98% chance of a 97% return (7% per year for 10-years) and a 2% chance of -100%. That's an expected return of 93%.

Now let's say that they can borrow an amount equal to 1/3 of their current equity and return it to shareholders as a special dividend. And let's say that after expenses of the new debt, that results in ROE of 10%. How much does the chance of bankruptcy really increase here? We assumed the company had very stable earnings. So double the risk? Triple? Let's use 7.5%, which is the historical figure for Baa-rated companies. If you assume 94% chance of 160% return and 7.5% of -100%, that's an expected return of 143%.

Most investors would rather the higher expected return, even if the variance of possible returns is greater. I say this with confidence, because most investors choose to own more stocks than bonds.

So the reward to shareholders of increasing risk? Maybe not more wealth than you can imagine, after all, I can imagine quite a bit. But if the question is "Does increasing financial risk serve shareholder interest?" I think the answer is "Sometimes, yes."

6 comments:

Anonymous said...

If I'm doing the math right, ROE of 7% for an all equity firm, and an ROE of 10% for a one-third debt, two-thirds equity firm, implies a borrowing cost of 1%, which seems a little low.

TDDG said...

I completely made up the numbers to illustrate the point. I'm sure you are right. In reality a Debt/Equity ratio of 0.33 would probably not garner a Baa rating anyway so my numbers aren't perfect.

Anonymous said...

if you remember from your intro to finance class, leverage does not matter. in other words, it is true that by levering up, a corporation can move up the returns by taking on a higher level of risk. at the same time, a stockholder can achieve the same returns by buying an unlevered stock on leverage. thus, different investors can attain their desired levels of return and leverage by purchasing an unlevered security at various leverage points on their portfolio.

TDDG said...

Well, only if the investor can borrow at the same cost as the company. You make a fair point though.

Robert said...

Off topic, but...

What do you think about Mssr. Gross' latest rant regarding contagion/subprime and CDOs?

Due to your prior posts, I am going to assume that BILL GROSS IS LYING. Given that, what is his angle?

TDDG said...

Great minds think a like Robert... see the new post...