A Question of Company Valuation

One of the advantages of being infamous for having no knowledge of fundamental analysis or for the inability to understand company valuations is that one can ask basic questions without worrying about sounding stupid.

Let me explain. If there are two traders A and B both with Rs 100mn capital. A makes a return of 20mn and B makes a return of 40mn. Which trader is better? The answer depends on whether B made the higher return with a higher leverage. If B had a leverage of 3 times and yet made a lower percentage return on exposure then in all probability A is a better trader despite making a lower absolute return. There is not much dispute when it come to this.

However when a Company A makes a profit of Rs 20mn on a capital of Rs 100 and no debt and Company B makes a profit of Rs 40mn on the same capital but with a debt of Rs 200mn, company B is almost always given a better valuation by the market. Even giving it a PE equal to Company A will make Company B's share price 2 times that of company A despite the same share capital. This surely is a travesty because Company B is in the habit of taking more risk which is all right during times of expansion but can cause substantial damage in bad times. If anything, Company B deserves a lower valuation to adjust for the higher debt burden.

The markets do not perform this function efficiently because debt and consequently leverage taken by a company is not considered as dangerous as leverage taken by a trader. The fact that leverage beyond 20-30% is bad for everybody is generally ignored totally by the markets allowing company managements to increase EPS during good times by simply upping the leverage.

Well all this was written to just ask this simple question. What valuation metric takes into account the debt component while valuing shares? Is there something like that out there? Something like the P/E ratio?

BTW I am short the Nifty as you are all aware and will continue to be short until 5350 is taken out. The caveat is that if Nifty futures trades below 5055 tomorrow then I will cut my short positions if 5210 is crossed. This is all that I have to say about my trading bets.

Finally a PJ to make you think if, like me, you have nothing much to do today. Let A be defined as a function of (x,y) where fn(x,y) = 2y/x. What would you think A is called?  Remember this is a PJ and not a mathematical riddle. Okay here is a hint if x is 1 and y is 2 then fn(1,2) = 4 and if x is 4 and y is 2 then fn(4,2)=1 Now what is A called?