The Power of Ratios For Successful Stock 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 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 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 illustrates the proportion of debt and equity the company is utilising to support its assets. If a ratio is high, this corresponds to a situation where debt is mainly shoring up the company. The principal dilemma with a high ratio is that it renders earnings volatile and leaves it at the mercy of interest rates, which can be expensive.
Buffett pays a lot of attention to the results of this ratio and the reasons behind this is a important lesson for all investors. He doesn’t differ from other investors, in that he would much prefer companies which have a low amount of debt and the reasoning behind this that a low amount of debt implies income growth is being derived from shareholders’ equity rather than borrowed money in the form of loans. The problem is that if a company uses loans to prop up its income, this normally leads to a vicious cycle of debt and repayments forming which in inherently inconsistent and dependant on the level of the rate of interest.
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!
