July 16, 2008
The Power of Ratios For Successful Stock Investing
By Martin Sejas
The fourth part of this series deals with the debt/equity ratio, which is another key component of Warren Buffett’s legendary methodology. In fact, it is a component that the man himself treats very carefully when deciding which stocks to invest in. Just like the return on equity in the previous part of this series, it is an equation that is commonly used in finance, however, Buffett is the one who makes the most and greatest use of it.
The debt/equity ratio is made up of 2 obvious parts and it’s almost certain that everyone has come across the term some time in their lives, whether it be at school or at another educational institutions. However, some people may not be too familiar with the term, which is why I will now explain it. The debt/equity ratio is equal to total liabilities being divided by shareholders’ equity.
Both components of the ratio can be easily obtained by accessing a company’s balance sheet, which is also sometimes known as a statement of financial position. This process of finding and taking these numbers is known as taking the ‘book value.’ However, if the debt and equity was being traded publicly, you are able to use the market value if you choose to. Furthermore, you will have the option of using a combination of both.
The ratio displays the percentage of equity and debt the company is employing to finance its assets, and a higher ratio indicates that debt is principally propping up the company. The major complication with possessing a high ratio (which indicates a high level of debt when compared to equity) is that it tends to make earnings volatile and be the subject of large interest expenses.
This is something that Buffett takes very seriously and it’s important to understand the reasons why. Like everyone else, he prefers to see a small amount of debt and the reason why is that small amount of debt means that earnings growth is being generated from shareholders’ equity as opposed to borrowed money. If a company is using borrowed money to finance its earnings, this tends to commence a vicious cycle of debt and repayments which is volatile and which is at the mercy of interest rates.
So the message to take from Buffett is to concentrate on companies which have a low ratio, or at least a low ratio compared with other companies in the same industry. This involves a bit of work from your part in trying to calculate the ratios for each company, but as I said earlier, the required information is freely available on company reports.
Some investors use only long-term debt instead of total liabilities in the calculation of the ratio. This could prove to be more useful and convenient as investing in stocks is for the long-term not the short-term. This is not just my own personal view, but Warren Buffett’s own way of thinking.
The fifth and final section of this publication will concentrate on one final component of Buffett’s methodology known as profit margins. Coming soon!
Topics: Investment |
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