posted by on Jul 7
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 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 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.
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 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!
