Expensive Stocks Make for Good Bonds

I asked last week what I should think about Netflix Theory, a half-joking name for the idea that a company should be able to issue debt cheaply, even with limited assets and cash flows, as long as it has a big enough equity market capitalization.1 I mentioned some possible explanations for this theory: that the companies could always raise new equity to pay off the debt, or just the efficient-markets explanation that if shareholders valued the company so highly that must mean that it really has plenty of assets or cash-flow generation. But mostly I was genuinely asking what I should think, and I got some good responses, which I will now tell you about.

First here is one good argument against Netflix Theory, or rather against the efficient-markets form of it that says “well if a company has $10 billion of debt and $125 billion of equity market capitalization, that really means that its assets are worth $135 billion and that’s plenty to cover the debt.” That form of the theory is wrong because it doesn’t take into account the dispersion of equity outcomes. Let’s say a company’s entire assets are a coin-flip project — a drug in development or an oil well being drilled — that will be worth either $0 or $270 billion with equal probability, and it has $10 billion of debt. The expected value of that project is $135 billion; if you subtract the debt you get a $125 billion fair value for the equity.2 So that’s a valuable company, to the equity markets. But it’s a disastrous credit: With 50 percent probability, it will default with zero recovery. You should charge like a 100 percent interest rate to lend to that company.