Mental Models discussed in this podcast:
- Potential Energy vs Kinetic Energy
- All Else Equal
- First Principles
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Companies with no debt are better than companies with debt (Investing First Principle) – Show Outline
The full show notes for this episode are available at https://www.diyinvesting.org/Episode34
Mental Model: Potential vs Kinetic Energy
- There is a concept in physics called potential energy and kinetic energy.
- The basic explanation is that potential energy is the energy available in an object to perform work. Meanwhile, kinetic energy is a measure of the current energy an object possesses due to its motion.
- Example: Water held in a lake behind a dam. (A lot of potential energy) This energy can be used to produce electricity if the water is allowed to flow through turbines at the bottom of the dam. Yet, once the water is released, the potential energy no longer exists. Instead, it has been converted to kinetic energy, creating motion, and electricity. You’ve used up potential future gain for the benefit of the present.
How does this apply to companies and investing?
- A company without debt is like water held in a lake behind a dam. It has a lot of potential energy. When a company has no debt, there is the possibility of adding debt in the future in order to increase earnings and therefore returns.
- However, a company with large amounts of debt is like water already past the dam. There is no longer any potential to quickly increase earnings by taking on additional debt. Instead, you have to “PAY” cash to reduce debt if you’d like to gain additional potential energy in the future.
- In our water example, this would be analogous to pumping the water back uphill to put it behind the dam again.
Debt also increases risk
- Companies without debt or liabilities cannot go bankrupt.
- However, the presence of debt creates the possibility of bankruptcy.
- When you own companies with medium or high levels of debt, you are taking on the risk of permanent wipeout of your capital due to bankruptcy.
- While the additional return is possible due to leverage, your risk is inherently higher.
Debt creates automatic forced future payments
- The value of a company is the net present value of future cash flows available to be paid to you in dividends.
- If a company has debt, any earnings in the future must first be used to make interest and principal payments on the debt, before you can receive any dividends.
- By owning companies that use debt to earn higher returns, you are allowing debt holders to have the first claim on future cash flows.
“All Else Equal” considerations
- Debt creates leverage – While leverage can be dangerous it can also provide benefits. It is possible that the leveraging effects of debt can allow a company to increase its returns.
- This is why I use the term “all else equal.” You need to compare apples to apples.
- If a company provides 10% returns with no debt, this is inherently better than a company that provides 10% returns while holding large amounts of debt. The debt-free company is lower risk.
- This investing first principle doesn’t apply if you are trying to compare a 10% returning debt-free company to a 20% returning high debt company. That’s not a fair comparison.
Companies without debt are better investments than companies with debt, all else equal. While debt can provide the benefits of leverage, you must never forget the risks. If debt-free companies offer returns that exceed your discount rate, then you should always prefer them over debt-laden companies.