Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you specific investment advice, including the best use of financial ratios in your stock market research. Each Investor Toolkit update gives you a fundamental piece of investing strategy, and shows you how you can put it into practice right away.
Today’s tip: “When you’re trying to assess whether a company can manage its debt, the most popular ratio may actually be misleading.”
In recent years, debt has captured many headlines—whether it’s the heavy burden of government debt or the indebtedness of the population at large. It’s also important for investors to determine whether a company is carrying too much debt.
Experienced investors often begin their stock research by looking at indicators such as a company’s debt-to-equity ratio. This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity.
A high ratio of debt to equity increases the risk that the company (that is, the shareholders’ equity in the company) won’t survive a business slump. However, this ratio can mislead, because it compares a hard number with a soft one.
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Debt is usually a hard number. Bonds and other loans generally come with fixed interest rates, fixed terms of repayment and so on. Equity numbers are not as precise. They mostly reflect asset values as they appear on the balance sheet—minus debt, of course.
But figures on a balance sheet may be misleading. They may be too high, if the company’s assets have depreciated since it acquired them (that is, depreciated more than the company’s accounting shows). In that case, the company will eventually have to correct the balance-sheet figures by trimming them back or “taking a writedown.”
Or, the equity value may be too low if the company’s assets have gained value since the company acquired them. This can happen with real estate and other investments.
Why debt-to-market-cap is a better long-term guide
Instead of overemphasizing the debt-to-equity ratio, we recommend that you expand your research to look at the ratio between a company’s debt and its market capitalization or “market cap” (the value of all shares the company has outstanding).
Like shareholders’ equity, market cap may differ widely from the net value of a company’s assets. However, a moderate debt-to-market-cap ratio will tend to provide a conservative starting point for analyzing a company’s chances of survival.
One great example is Coca-Cola Co. (symbol KO on New York). The company has long-term debt of $16.2 billion, which represents a moderately high 49% of its $33.2-billion shareholders’ equity. But that debt is just 9.6% of its market cap.
The difference reflects the fact that the company’s balance sheet doesn’t show the true value of its most valuable asset — its so-called intellectual property. In Coke’s case, one key asset is the secret formula for Coca-Cola, which is reputedly carried on the company’s books at one dollar (and last year was moved with great fanfare to a new vault in Atlanta). More important, the Coke brand name carries no value on the company’s balance sheet. However, these hidden assets are reflected in its huge market cap of $167.7 billion. So, when you put it all into perspective, the company’s debt is very low.
In contrast, penny mines often have low debt-to-equity ratios. But their shareholders’ equity reflects a lot of investments in mineral properties that will almost certainly never result in any significant revenue. One good reason that their debt is low is simply that no one wants to lend them money.
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Do you have a particular financial ratio—or more than one—that you rely on most often when you are looking at stocks? What does this ratio (or ratios) tell you about a stock? Let us know what you think.
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