Buffett's Guide To Value Investing (Part 4)
The components that make up the debt/equity ratio are fairly obvious and I'm certain that many people first heard of it in high school in a commerce or business class. But just in case, there's still some confusion, I will give a quick, brief explanation. The debt/equity ratio is given by total liabilities of a company divided by shareholders' equity.
Both total liabilities and shareholder's equity can be found on a company's balance sheet (sometimes known as the statement of financial position). This is known as taking its 'book value'. On the other hand, if the concerned company's debt and equity are publicly traded, you can use the market value instead. There is also the possibility of using a mixture of both the book and market value.
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.
Several investors choose to only use long-term debt rather than total liabilities when calculating the ratio. This could be more effective and handy as stocks investing is for the long run not the short run. This doesn't come from my own personal view, but in fact it's part of Warren Buffett's own methodology.
The next and final part of this series will focus on the remaining element of Buffett's methodology - profit margins, an undervalued concept in finance today. Stay tuned!
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