Discover how the debt-to-equity ratio measures corporate leverage, uncovers hidden assets, and indicates a company’s likelihood of thriving beyond market slumps.
When analyzing a stock, you need to form an idea of how likely the company is to survive a business slump and go on to prosper when economic growth resumes. To do that, you need to look at a variety of factors, including how sensitive the stock is to the economic cycle, its advantages and disadvantages in relation to competitors, its vulnerability to adverse legal and regulatory decisions, its credit history and current credit rating, and of course, how much debt it has. One of the first tools investors often use is the debt-to-equity ratio—a measure of financial leverage that compares a company’s total debt with its shareholders’ equity.
Many successful investors start by looking at the debt-to-equity ratio because it offers a straightforward snapshot of how aggressively a company uses borrowed money. The basic assumption is that an attractive company can earn a higher return on its total capital than the interest rate it pays on the debt portion of that capital. When that happens, the excess goes to shareholders, raising the total return to shareholders’ equity. But leverage works both ways. If the total return falls short of the interest costs, the difference erodes shareholders’ equity.
Even when a company loses money, interest expenses don’t go away; the firm still has to pay them and eventually repay the principal. In many cases, it does so by dipping into shareholders’ equity. In extreme cases, losses can wipe out shareholders’ equity altogether, rendering the stock worthless. At that point, bondholders and other lenders often take over the assets to recover what they can. A high ratio of debt to equity, therefore, increases the risk that a company—and specifically its shareholders—will not survive a prolonged downturn.
However, the debt-to-equity ratio can mislead because it compares a hard number (debt) with a potentially soft one (equity). Debt is usually fixed: bonds and other loans come with set interest rates and repayment terms. Equity, on the other hand, largely reflects asset values as they appear on a balance sheet (minus debt), and those asset figures may be outdated. A company’s assets might have shrunk in value since they were acquired, requiring the company to issue a writedown. Or the assets may have gained considerable value, especially in cases of real estate, patents, or other so-called “hidden assets.” In addition, intangible factors like brand reputation or “goodwill” rarely appear at their true worth unless they were purchased from another firm.
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Because of these uncertainties, many analysts increasingly look at the ratio between a company’s debt and its market capitalization—sometimes called “debt-to-market-cap”—as a more realistic measure of risk. Market cap reflects the collective judgment of all investors who buy and sell the stock, often referred to as “the wisdom of crowds.” Although the market can be too euphoric during bubbles or too pessimistic during crashes, it reviews a company’s prospects every trading day. This constant review can help you gauge whether a company’s underlying value justifies its amount of debt more effectively than a single snapshot of balance-sheet figures.
A well-known example is Coca-Cola (symbol KO on the NYSE). At one point, the company’s long-term debt stood at $28.4 billion, or 111% of its $25.6 billion in shareholders’ equity. Measured strictly by the debt-to-equity ratio, that sounds high. But compared to its market capitalization at the time—$201.4 billion—this debt amounted to just 14%. That big gap is due to Coca-Cola’s enormous intangible assets, such as its famous Coke brand and secret formula. The balance sheet doesn’t reflect these hidden assets at their true worth, but the stock market does. Hence, debt amounted to a modest share of the firm’s market value, putting it in a far stronger position than the balance sheet alone might indicate.
Hidden assets can consist of anything from undervalued real estate to underused brand names or even high research-and-development spending that continually generates new products. Companies whose hidden assets are underestimated by investors often trade for less than they’re truly worth. That provides an attractive entry point for savvy buyers—and can also attract takeover bids from corporate acquirers who see those undervalued assets.
In contrast, consider some of the ultra-speculative “penny mines” that you see trading at very low share prices. Many of them appear to have a low debt-to-equity ratio on paper, yet that ratio is based on shareholder equity figures that reflect the presumed value of mineral properties. If these properties never generate significant revenue, the so-called low ratio is meaningless. Sometimes, penny mines have low debt simply because few lenders are willing to provide them with capital.
Institutional investors often rely on even more detailed measures—examining debt structures, legal and regulatory risks, and intricate derivatives contracts. Yet even these professionals sometimes let conflicts of interest or herd thinking lead them astray, especially if they ignore the practical lessons that underlie efficient market theory.
It takes more than a single metric to fully assess a company’s risk of failure, but the debt-to-equity ratio is a convenient starting point. We now often leave it out of our published analyses in favour of debt-to-market-cap, since that figure accounts for hidden assets and intangible value more accurately. Still, the debt-to-equity ratio can serve as an early warning sign of whether a company is overextended and how vulnerable it might be in a slump. If the ratio is sky-high, it’s a good reason to think twice before investing. After ruling out stocks that take on too much leverage (or misuse funds in other ways), you’ll have more time to focus on higher-quality companies—those with a real chance to survive and prosper over the long haul.
Which metric do you believe better captures a company’s real-world financial risk: the traditional Debt-to-Equity Ratio or the market-driven Debt-to-Market-Cap ratio—and why?
