There’s been a lot of attention paid to the amount of equity that has been removed from the markets by corporate takeovers and buyback programs. Bloomberg recently put the number at about $5.5 trillion. While it’s true this does reduce the supply of corporate equities in the markets it’s only half of the story. The other half of the story is about how those buybacks and takeovers were funded.

…resulting in a nearly commensurate increase in corporate debt securities over that time: pic.twitter.com/hTpJl0ZQrD

— Jesse Felder (@jessefelder) August 29, 2017

At the same time that $5.5 trillion in equity was being removed from the markets a nearly commensurate amount of corporate debt was being issued. Essentially, what we have seen then is a massive swap of equity liabilities for debt liabilities leaving corporations much more highly leveraged than they have ever been in the past.

It may be true that this trend towards “de-equitization” is largely responsible for the massive rise in share prices over the better part of the past decade. However, while it may help to explain the phenomenon it’s important to note that it doesn’t justify higher equity valuations. In fact, it should be just the opposite.

Imagine two identical companies. The only difference between them is one is financed entirely with equity; it has no debt. The other is financed partly with equity but also with a large heaping of debt. Should the equity of both enterprises be valued equally? Or should the leveraged company’s equity valuation be reduced by the amount of net debt on its books?

I believe the latter is the correct answer. And if you think of equity valuations as a potential acquirer of a business does this is the only approach that makes sense. Because when you buy a company in its entirety, you must assume the net debt on that company’s balance sheet as a sort of premium to the price you pay for its equity. This is essentially just the concept of “enterprise value.”