Of the many ratios to measure risk with a particular stock, the Net Debt to EBITDA ratio is one of the more common you’ll see listed in company financials. The logic is simple, and the ratio isn’t terribly complex, so I’ll show you how to easily source it in this post.
I’ll also reveal the median Net Debt to EBITDA ratio of the S&P 500 over the last 20 years, so that investors can compare this debt ratio to the average for better context.
Feel free to skip around to what parts of this article suits you best, but I highly recommend reading the whole thing through since it all builds on itself. The sections include:
- The Basics of Debt Ratios
- How to Calculate the Net Debt to EBITDA Ratio
- Why a High Net Debt to EBITDA Ratio Can Be REALLY Bad
- Net Debt to EBITDA is Not the Only Component of Risk (with an example)
- Average Debt to EBITDA of the S&P 500 – 20 Years
- Average Debt to EBITDA of the S&P 500 – By Industry
I hope this is as fun of a read as it was to write. Let’s dive in.
The Basics of Debt Ratios
First, debt ratios are important for investors because they can help measure a company’s risk of default. After all, the risk in buying a stock is losing money on that investment—but the truth of the matter is that stocks rise and fall all the time and for many different reasons. You don’t actually lose money on a stock until you sell, and so short term fluctuations in price shouldn’t mean a stock is more risky to you if you’re a long term investor.
The real risk is a forced sell, which is what happens if a company goes bankrupt. A company goes bankrupt when it can’t pay its obligations, such as long term debt payments, and so that’s why debt ratios can provide context on how difficult it might be for a company to make good on its debt obligations in the future.
Common debt ratios used by investors today include:
- Debt to Equity ratio
- Long term Debt to Equity Ratio
- Cash-to-Debt ratio
- Interest coverage ratio
The list really could go on-and-on, but the goal of these debt ratios is the same thing.
The Net Debt to EBITDA ratio is a similar ratio, but is more precise than a Debt to Equity ratio (for example) because it considers earning power rather than just a balance sheet.
This measurement of earning power becomes ever more critical as company assets increasingly become intangible, and old school assets seemingly produce less earnings power as technology improves and intangibles such as brand power and technological edge become higher profit generators.
How to Calculate Net Debt to EBITDA
To understand this ratio, you first need to understand how each metric above is calculated.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization—which is a mouthful if you’re not familiar with accounting. For an in-depth breakdown on EBITDA, I’d recommend this introductory post we also have on the site.
Another way to think of EBITDA is as Operating Income, which is frequently found in the Consolidated Income Statement and is sourced from revenues in the following way:
-minus (COGs) Cost of Goods
= Gross Profit
-minus (R&D) Research and Development
-minus (SG&A) Selling, General & Administrative
= Operating Income = EBITDA
The other side of the Net Debt to EBITDA formula is Net Debt, which is the following formula:
Net Debt = Short Term Debt + Long Term Debt – Cash and Cash Equivalents
You can find the variables for Net Debt quite explicitly in the Consolidated Balance Sheet of a company’s 10-k, and quickly calculate the final formula from there. The formula is:
Net Debt to EBITDA Ratio = Net Debt / EBITDA
One of the definitions for this ratio that I’ve heard on the Street is that anything above 4x is considered high.
We’ll get to the actual data from the history of the S&P 500 in a minute, but that makes for a good starting point.
Another way to think about the Net Debt to EBITDA ratio is that it tells you how many years (roughly) it would take for a company to pay off its debt.
EBITDA more accurately represents a company’s real cash flows (since D&A are non-cash expenses), but also has its limitations/ complications (interest and taxes are real cash flow expenses that are intertwined; in other words, interest reduces tax expense but does require a real cash outlay).
Basically, it’s a decent estimate, and a good comparison tool against its history, its competitors, or even the overall market.
Why a High Net Debt to EBITDA Ratio Can Be REALLY Bad
The thing about long term debt is that while interest expenses on the debt get reflected in the Income Statement (and are generally tax deductible), paying off the principal of a debt gets taken out of free cash flows, and represents money that can’t be reinvested in the business or paid back to shareholders (in dividends or buybacks).
So if you are attempting to value a company based on free cash flows (using something like a DCF model), then you have to take Long Term Debt into consideration, because it reducing the future cash flows which make up the intrinsic value of your investment.
One way to do this in your DCF model is to differentiate between FCFF (Free Cash Flow to Firm) and FCFE (Free Cash Flow to Equity), but that’s another topic for another day.
The bottom line is:
The higher Net Debt to EBITDA that a company has, the more payments the company has to make towards its principal to come out of free cash flows.
If this debt level is excessive, it could represent a company that’s being overvalued.
Advanced Topic: Why Paying Off Debt isn’t Included in FCF Estimates for a DCF
Though debt principal payments do come out of free cash flow, its reduction of future free cash flow should not reduce the valuation of a company as long as the company maintains the ability to consistently make regular payments on its debt (just interest payments for a Senior Note with a bullet maturity) and/or refinance its debt.
Most companies maintain some level of debt indefinitely, as debt is a fantastic tool to maximize capital allocations if used prudently.
So, assuming a healthy bond market, companies should be able to continue to maintain a prudent level of debt as long as they can maintain a prudent level of profitability.
A reasonable Net Debt to EBITDA helps confirm to the investor that this is likely the case, and that the company has a good level of financial leverage.
That all to say that, though Debt Principal payments come out of FCF, they should not reduce the valuation of a company based on FCF. Taking the opposite case, if a company were to add Debt, you wouldn’t add that to a Free Cash Flow valuation since it’s not for free (the company owes it later).
In the same token, you don’t subtract (principal) debt payments out of the Free Cash Flow valuation as it’s assumed that most companies won’t pay off their debts in full but rather keep a steady level of financial leverage.
It’s mostly accepted today that a company’s debt is evaluated separately from valuation, but should not detract from valuation if the company seems mostly free of the risk of default.
We’ll see if that logic changes when/if interest rates rise.
Advanced Topic: How Paying Off Debt Does Affect (DCF) Valuation
Using FCF to pay off debt does manifest itself in a DCF valuation in the way of reducing the Discount Rate.
Since WACC is generally used for the discount rate, and a less leveraged Balance Sheet should drive down the future Cost of Debt (component of the WACC), then the valuation should improve as debt is paid off, just as the valuation would decrease if a company has too much debt (resulting in a higher Cost of Debt, resulting in a higher WACC, resulting in a higher discount rate).
Net Debt to EBITDA is Not the Only Component of Risk (Example in a 10-k)
Simply seeing a company with a high Net Debt to EBITDA ratio and calling it a day can leave out some great companies with growth potential that are actually less riskier than they seem.
Let’s take company Griffon Corporation ($GFF) as a great example of this.
In any company’s 10-k, you can see a detailed break-out of not only what kind of debt the company has, and at what interest rate they are paying on, but also what the schedule of those debt payments are.
From $GFF’s latest 10-k, search (Ctrl+f) “Contractual Obligations” (or just “obligations” if your company calls it differently) in order to see their debt repayment schedule:
You can see from the Contractual Obligations table that the company has a large debt repayment due ($1.1B), but not until the 1-3 Year mark.
We can get more precise information by searching “debt”, in which case we see this table explaining the various debt instruments in Footnote 10—Notes Payable, Capitalized Leases and Long-Term Debt.
The vast majority of that $1.1B due in 1-3 years consists of the Senior Note due 2022 with an Outstanding Balance of $1B and a Coupon Interest Rate of 5.25%.
Knowing that the company currently has a Net Debt to EBITDA of 4.8x (self reported by the company using adjusted EBITDA), and earned FCF of around $68 million in 2019, this $1B might start to become a cause for concern for investors and prospective investors, unless the company can successfully refinance that debt.
Turns out, that was exactly what $GFF was able to do.
From following their 8-k’s through 2020, I was able to see that $GFF was able to refinance the entire $1B principal into a Senior Note due 2028. You can see the difference in their latest 10-q:
Getting more clarity on the Senior Note by scrolling down:
Clicking through into the 8-k filed by the company on June 22, 2020, we see terms of repayment (since the new 10-k reflecting this refinance hasn’t been released yet):
Notice that after this refinance, the Net Debt to EBITDA for $GFF hasn’t changed, but the riskiness of investing in this company has reduced greatly now.
Since this Senior Note is on a bullet maturity (meaning only interest payments are made, and the entire principal is paid in full in 2028), the company has a long ramp ahead (8 years!) of free cash flow usage towards growth and shareholder yield.
Following the footnotes to the Debt tables reveals the repayment structure of the Senior Note (we know now it’s a bullet maturity), and completes our understanding on the company’s debt situation.
Now all of a sudden, the company’s Net Debt to EBITDA of 4.8x, doesn’t seem so bad—especially when you consider that as long as the company maintains high growth of EBITDA, their future Net Debt to EBITDA ratio will decrease and make securing a new Senior Note much easier.
Average Debt to EBITDA [S&P 500] – 20 Years of Historical Data
Next I’ll show you what you’ve probably all been waiting for, the cold hard data about some of the best companies in the world, those in the S&P 500.
To create this dataset, I simply took the current S&P 500 list of companies (as of 10/30/20), and inputted their EBITDA and Long Term Debt into a spreadsheet. Then I took the median value of every company, excluding the values where Long Term Debt wasn’t reported accurately (datasets are still being improved even today for particularly specific metrics such as Long Term Debt).
Here are the results:
We can see that the Debt to EBITDA is steadily increasing, but we also should know that this has happened alongside falling interest rates (for 40+ years!), and amidst record low interest rates since the pandemic of 2020.
Remembering that the Long Term Debt value without context can be misconstrued, it’s likely that many of the companies in the S&P 500 have been taking advantage of the lower interest rates to lock in those favorable terms while deploying that capital for future growth in their businesses.
Also, the actual Net Debt to EBITDA ratios might be lower (or slightly higher!) due to this dataset solely looking at Long Term Debt rather than Net Debt (which includes cash and short term debt).
Average Debt to EBITDA of the S&P 500 – By Industry [The 11 Sectors]
I took the dataset one step further to segment the ratios by major sector, for the pleasure of all of you spreadsheet guys and gals.
Please understand that since each column takes the average rather than the median value for each industry (we’ve reached the limit of my Excel PivotTable skills here), there are a few data points where the reported value is wildly misrepresented due to an extreme value heavily biasing the result.
We can see that the Debt to EBITDA ratio can vary wildly from industry to industry, which makes sense because some industries are much more capital intensive than others.
Additionally, each of the businesses is on its own path in the life cycle of its industry, which affects the cost of capital for those businesses depending on many outside factors—future expected growth, competitiveness and pricing power in a market, and more.