Tuesday, April 21, 2009

Concentrate On Value Part III - Debt/Equity Ratio

As I wrote in my previous two Post, Ignore the headlines and stick with the facts at hand, not the B.S. that is hyped in the media or the tips you hear at a party. Investing, although not so simple can be enjoyable and profitable if you approach it in the right manor. As mentioned in my previous two posts book value, free cash flow and return on equity are just some of the tools used to finding the right business to invest in. Another tool to help guide you is the debt/equity ratio which is simply liabilities divided by the stock holders equity. A simple example of this would be: Take your homes current market value, say it is $200,000 dollars and lets say you owe the bank $100,000 dollars, your debt-to equity ratio is 1.0 or 100 percent. Lets also take your neighbors home current value of $200,000 dollars and suppose he/she owes $150,000 dollars. The debt/equity ratio is $150,000/$200,000 3.0 or 300 percent. In this formula we are looking for low debt/equity ratio's. The lower the better. However keep in mind that some industry's will have higher figures than others. Also take note that this is how many company's finance their growth,however if the debt/equity ratio gets to be to high this could be a warning sign to get out or stay away altogether. Also let me reemphasize that you should never take just one of these methods all on its own. Choosing a stock using a combination of these methods can yield some profits for the patient investor with an eye for value.
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5 comments:

  1. John PrendergastApril 21, 2009 at 5:57 PM

    I've been following the blog for a bit now and like what you're doing. There aren't enough sane voices out in the investing wilderness. One thing I'd suggest is helping your readers separate out valuation approaches from risk and earnings quality measures. The above being the latter. Keep up the great work. In addition to the influences you mention which are similar to my own, I'd recommend Seth Klarman.

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  2. Enoch KoApril 22, 2009 at 1:18 AM

    I'd just like to point out a technical error. The values you calculated were the debt-to-asset ratios. The lower-is-better principle still holds, but the calculated values turn out quite different. When you run screens and input the "wrong" values, the screen will include companies that, according to your standard, should have been left out.

    The debt-to-equity ratio is debt divided by equity, which is asset minus liability.

    So:
    Asset (house) = $200,000
    Liability (mortgage) = $100,000
    Equity = Asset - Liability = $100,000.
    So your debt-to-equity ratio would be 1.0 or 100%.

    And for your second example, that would be $50,000 equity over $150,000 debt, so the debt-to-equity ratio should be 3.0 or 300%.

    Debt-to-equity and debt-to-asset ratios are generally convertible to each other, except when you are calculating interest-bearing long-term debt-to-equity, for which you would exclude short-term and trade liabilities from the "debt" figure.

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  3. STOCKMANMARCApril 22, 2009 at 7:29 AM

    John,

    Thanks for your input, always welcome!
    I'm glad you like the blog, keep coming back. If you have anymore advice I'm all ears.

    Thanks

    ReplyDelete
  4. STOCKMANMARCApril 22, 2009 at 7:36 AM

    Enoch,

    Thanks for the heads up! I probably should have used a stock in the example, however was thinking that most people can relate to the house example better.

    Hope you enjoy my blog overall.

    Thanks

    ReplyDelete
  5. Jae JunApril 24, 2009 at 1:19 AM

    Thanks for the post and explanation Stockmanmarc

    ReplyDelete

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