Debt-to-equity ratio analysis won’t always reflect the true financial strength of a company

When analyzing a stock, you need to form an idea of how likely the company is to survive a business slump and go on to prosper all the more when economic growth resumes. To do that, you need to look at a variety of factors, including debt-to-equity ratios. The goal is to figure out how sensitive the stock is to the economic cycle, its advantages and disadvantages in relation to competitors and so on. And very important is how much debt it has.

Experienced investors start by looking at ratios—including undertaking a debt-to-equity ratio analysis. This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity. In essence, you assume an attractive company can earn a higher return on its total capital than the interest rate it pays on the debt portion of its capital.

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In that case, excess profits accrue to shareholders, and that in turn raises shareholders’ equity on the balance sheet. But leverage works both ways. If the total return falls short of interest payments, the difference comes out of shareholders’ equity.

Even when a company loses money, it still has to pay the interest and eventually repay the debt. Generally it does so by dipping into shareholders equity. In extreme cases, losses wipe out shareholders’ equity and the stock becomes worthless. Then bondholders and lenders take over the remaining assets to try to get back their investment.

A high ratio of debt to equity increases the risk that the company won’t survive a business slump.

However, a debt-to-equity ratio analysis can mislead because it compares a hard number with a soft one.

Debt is usually a hard number. Bonds and other loans generally come with fixed interest rates, fixed terms of repayment and so on. Equity numbers are not as precise. They mostly reflect asset values as they appear on the balance sheet—minus debt, of course. The debt-to-equity ratio combines those two disparate values.

But figures on a balance sheet may be misleading. They may be too high, if the company’s assets have depreciated since it acquired them (that is, depreciated more than the company’s accounting shows). In that case, the company will eventually have to correct the balance-sheet figures by trimming them back or “taking a writedown.”

Or, the equity value may be too low if the company’s assets have gained value since it acquired them. This can happen with real estate and other investments.

Coca-Cola makes the case for debt-to-market cap as the superior measurement

A company’s real value may also be in its “goodwill”—its brand, or the reputation and relationship it has built up with customers over the years. This value would only appear on the balance sheet if it was acquired rather than built up by the company’s operations.

You could write a book on this subject.

For the moment, though, we just want to explain why we now often leave the debt-to-equity ratio analysis out of our published analyses and instead mention the ratio between a company’s debt and its market capitalization, or “market cap” (the value of all shares the company has outstanding).

Like shareholders’ equity, market cap may differ widely from the net value of a company’s assets. However, a moderate debt-to-market-cap ratio will tend to provide a conservative starting point for analyzing a company’s chances of survival. Let me give you one very good example.

Coca-Cola Co. (symbol KO on New York) at one point had long-term debt of $28.4 billion, which represented 111% of its then $25.6-billion shareholders’ equity. But that debt was just 14% of its market cap.

The difference reflects the fact that the company’s balance sheet doesn’t show the true value of its most valuable asset —its so-called intellectual property. In Coke’s case, one key asset is the secret formula for Coca-Cola, which is reputedly carried on the company’s books at one dollar (and was moved with great fanfare to a new vault in Atlanta). More important, the Coke brand name carries no value on the company’s balance sheet. However, these hidden assets are reflected in its huge market cap, then $201.4 billion. So, when you put it all into perspective, the company’s debt was very low at that point in time.

Hidden assets are a huge plus

By hidden assets, we mean assets that are getting less investor attention than they deserve. When assets are wholly or partly hidden or ignored, a stock trades for less than it’s worth. So buyers get a bargain. These are also some of the best stocks for attracting takeover bids from corporate acquirers, who are usually looking to buy asset bargains, just like us.

Hidden assets can consist of real estate or underused brand names. For example, companies often carry their real-estate assets on the corporate books at its purchase price, even though its value has multiplied many times over the years.

Research and development spending by technology stocks is one of today’s best-hidden assets. High research and development budgets allow many stocks to keep adding profitable new products to their lines and improving existing ones.

In contrast, for example, penny mines often have low debt-to-equity ratios. But their shareholders’ equity reflects a lot of investments in mineral properties that will almost certainly never result in any significant revenue. One good reason that their debt is low is simply that no one wants to lend them money.

Do you perform a debt-to-equity ratio analysis on the stocks you’re looking to invest in? Do you have another financial barometer when analyzing stocks? Share your experience with us in the comments.

This post was originally published in 2012 and is regularly updated.