Companies that can sustain their own growth through positive free cash flow have long been prized on Wall Street. However, early stage companies and companies growing rapidly may not always be capable of realizing their growth opportunities without external financing. Finance professionals are trained to be indifferent between equity and debt as long as the relevant enterprise is able to achieve the lowest possible cost of capital. While the finance department may be agnostic as to capital structure, growth investors should pay close attention to how companies are financed. Growth firms with low debt-to-equity grow more quickly, attract a higher multiple, and appreciably outperform their peers.
Debt-to-equity is one of many ratios often included in measures of “Quality” as a quantitative factor. Quality factors frequently include some measure of profitability, return on assets or return on equity, and subjective assessments of either accounting or management. Along with the variables themselves, weights of these variables within Quality factor compositions are disparate. Our assertion is that studies of quantitative Quality factors are inconsistent in their construction and muddied by multiple inputs. Despite the factor construction anomalies, Quality has been tested to consistently show a positive statistical correlation with growth, and high quality is traditionally seen as supportive of higher valuations. Using a singular variable, (low) debt-to-equity, JAG produces comparable results to quantitative Quality factors. We believe debt-to-equity to be a singular powerful Quality factor for growth investing.
- Firms with Low Debt Grow Faster than Those with High Debt.
- The Market Pays More for Growth Stocks with Low Debt.
- Growth Firms with Low Debt Outperform Those with High Debt.
Data from Bloomberg arranged by JAG Capital Management displays that companies with net debt/equity have maintained higher long term EPS growth rates than those with higher net debt/equity. Over the past decade, the median long term EPS growth rate for low debt/equity companies is near 16%, while the median long term EPS growth rate for high debt/equity companies is near 11%. A five percentage point difference in annualized growth (45% spread) is meaningful in our opinion. As a potential explanation, it follows that companies with lower debt service requirements (interest payments) would have more cash to invest in growth initiatives. Managements operating lower debt companies may also be able to make decisions with less influence from bond holders. Whatever the motivation, low debt companies grow faster.
