The Most Important Ratio In Value Investing
This fourth section of this serial treats the subject of the debt/equity ratio, another important part of the successful methodology used by Warren Buffett. As a matter of fact, it’s something that Buffett considers crucial when picking his stocks. Much like the return on equity that was explained in the third section of this serial, this ratio is commonly employed in the financial world, however, Buffett has the ability to use it in a way that nobody else does.
The elements that comprise the debt/equity ratio are clearly evident and it’s very likely that many people first got acquainted with it in secondary school in a commerce subject. Nevertheless, some confusion may still reign, hence I will give a simple, short explanation. The debt/equity ratio is calculated by dividing total liabilities 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 shows the proportion of equity and debt the company is using to finance its assets, and the higher the ratio, the more debt (rather than equity) is financing the company. The main problem with having a high ratio (a high level of debt compared to equity) is that it can result in volatile earnings and 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.
Many investors prefer to use long-term debt rather than the traditional component, total liabilites, when they are calculating the ratio. According to many, this could prove to be more effective and convenient due to the long term nature of stocks investing. Among these people, Buffett is one of them.
The final part of this series will focus on the left over element of Buffett’s methodology - profit margins, an underestimated concept in finance today. Keep your eye out for it!
