The Most Important Ratio In Value Investing

by: MartinSejas
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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 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 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.

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.

What investors should take from this part of the series is that they should focus on companies that possess a low ratio, but not just any low ratio, it must be low compared to other companies in the same sector. It's not difficult to get the numbers necessary to calculate such a ratio, because as I highlighted in a previous paragraph, this is all available on company reports which themselves are publicly available.

Several investors choose to only use long-term debt rather than total liabilities when calculating the ratio. This could be more effective and handy as stocks investing is for the long run not the short run. This doesn't come from my own personal view, but in fact it's part of Warren Buffett's own methodology.

The fifth and final section of this publication will concentrate on one final component of Buffett's methodology known as profit margins. Coming soon!

About the Author

Author Martin Sejas is the chief writer of Stocks-And-Commodities.com, a leading stocks trading website dedicated to finding the best and the newest strategies and techniques for stocks and commodities trading. Its goal is to become the 'one-stop shop' on the best stocks trading websites and programs on the World Wide Web.  

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