Stock Value Finder

Companies have many options for financing operating activities, issue debt, issue stock, and using cash flow from operations among other things. One stock I have been following for a while now is E*Trade (NYSE:ETFC), which has been engaging in something called a debt for equity swap recently. I wanted to go into detail why I believe these swaps are good for shareholders.The basic idea behind one of these swaps is to issue equity equaling a debt load to pay off the debt. I am going to construct a simple example to explain the concept below.Consider the following:

Company Acme

• Revenue of $1,000,000
• Cost of running business $500,000/yr
• Original shares outstanding 100000
• Debt of 10 year $300,000 at 5%
• Shares trading at $50

Revenue $1,000,000
COGS $ 500,000
Interest Payment $ 15,000

Net Income = $485,000
Earnings per share = $485,000/100000 = $4.85/share

The company issues 6,000 shares at $50 bringing the share count to 106,000 and lowering the earnings per share from $4.85 to $4.57. The share count was increased by 6% and the earnings per share decreased by 6%. Now lets take a look at year two:

Revenue $1,000,000
COGS $ 500,000
Interest Payment $ 0

Net Income = $500,000
Earnings per share = $500,000/106,000 = $4.71/share

The earnings per share increased 3% from the reduction of the debt. This leaves more money in the company for operation, or dividends for shareholders. The company can initiate a share buyback to reduce the dilution from the swap. The company also has discretion about buying back stock, this freedom does not exist with a debt issue. Because of the freedom the company could buy back some of the stock if the price of the issue falls.

Ideally a company should never have to dilute shareholders in some situations it’s much better than being saddled with a big debt load. The debt for equity swap gives a company freedom in their financing activities and can allow a company to gain footing much quicker than issuing debt.

The news item that relates to E*Trade and this post can be found here: link

Disclaimer: I own a very small option position in E*Trade.

This entry was posted on Thursday, May 29th, 2008 at 3:55 am and is filed under investing, finance. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.