Understanding the Importance of the Debt-to-Market-Cap Ratio in Stock Analysis
When evaluating stocks, it’s crucial to assess their resilience during economic downturns and their potential for future prosperity. While the commonly used debt/equity ratio offers insights into a company’s financial leverage, it fails to capture certain nuances. In this article, we explore the significance of the debt-to-market-cap ratio in stock analysis and why it surpasses the debt/equity ratio.
By understanding the intricacies of this approach, investors can make more informed decisions and increase their chances of identifying companies poised for long-term success.
I was recently asked why I use debt-to-market-cap in my analyses, which is different from the debt/equity ratio seen in most other reports. My answer is two-fold. In analyzing a stock, you need to form an idea of how much it would get hurt in a recession. To put it another way, how likely it is to survive a business slump and go on to prosper when good times return? To do that, you need to look at a number of factors. These include the interest rate on its debt, how sensitive it is to the economic cycle, its pluses and minuses in relation to competitors, its vulnerability to adverse legal and regulatory decisions, its credit history and current credit rating … and so on.
Analyzing Debt-to-Equity Ratio
Many successful investors start by looking at the debt/equity ratio. 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. 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. If so, the excess goes to shareholders’ equity, raising the total return to shareholders.
But leverage works both ways. If the total return falls short of the interest costs, the difference comes out of shareholders’ equity. When a company loses money, it still has to pay the interest and one day settle 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 assets to try to get back their investment. A high ratio of debt to equity increases the risk that the company (that is, the shareholders’ equity in the company) won’t survive a business slump.
However, this ratio 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 softer or ‘‘fuzzier.’’ They mostly reflect asset values as they appear on the balance sheet (minus debt, of course). But the balance-sheet figures may be misleading. They may be too high, if the company’s assets have shrunk in value since the company acquired them (that is, lost more value than the company’s accounting shows). In that case, the company may need to correct its balance sheet figures by cutting them or “taking a writedown.”
Or the equity value may be too low if the company’s assets have gained value since the company acquired them. This can happen with real estate, patents and other assets (which we refer to as “hidden assets”).Much of a company’s real value may rest in its “goodwill” — its brands, or the reputation and relationship it has built with customers over the years. This value would only appear on the balance sheet if it was bought rather than built up by the company’s operations.
Efficient market theory also leads us to favour debt-to-market-cap over debt-to-equity. This theory says that it’s impossible to beat the market, because the market is efficient and eventually reflects all information, good or bad. This idea had a lot to do with the creation of index funds. Market cap — the value of all shares the company has outstanding — benefits from the “wisdom of crowds.”
The crowds get it wrong from time to time, of course. That’s what happens during the extreme highs of market bubbles and the extreme lows of bear markets. Their wisdom gets reviewed every day when the market is open. Institutional investors and portfolio managers have vastly more education and knowledge than the crowd, of course. They devote far more time and money to analyzing corporate debt, legal and regulatory situations and decisions, and so on. They need this information to be able to invest much larger sums of money than we deal with. They want to be able to trade in derivatives and other complex investments with high leverage.
But they still get taken in by conflicts of interest. They still get carried away and wind up making huge mistakes. That’s what they get for failing to keep efficient market theory in mind. It takes more than a debt-to-market-cap ratio to analyze a stock’s risk of failure. However, it’s one of the first things we look at when trying to decide if a stock is worth closer inspection. We also look for signs of excess borrowing, unwise use of corporate funds, and risk-heavy business practices. This is how we rule out a lot of marginal stocks very early in our selection process. This leaves us with more time to spot companies that have a real chance of going on to survive and prosper for years if not decades.
Use our three-part Successful Investor approach for all of your investments:
- Hold mostly high-quality, dividend-paying stocks.
- Spread your money out across most, if not all, of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance, and Utilities.
- Downplay or stay out of stocks in the broker/media limelight.
What do you look at when analyzing stocks? Do you use debt-to-market-cap?
Pat McKeough has been one of Canada’s most respected investment advisors for over three decades. He is the founder and senior editor of TSI Network and the founder of Successful Investor Wealth Management. He is also the author of several acclaimed investment books. This article was published on July 21, 2023 and is republished on the Hub with permission.