Two More Value Investing Points The D/E (Debt to Equity Ratio) and ROE (The Return on Equity Ratio)

Debt to Equity Ratio: This is a measure that is somewhat like a health barometer for a stock. If this ratio is too high, it's similar to having a high cholesterol count for your body. It's OK to have some of the stuff but too much will kill you. I'm talking about cholesterol and debt. This ratio is given in two forms, as a percentage or as a decimal. Also, this ratio is very straightforward: it measure how much debt a company has (the amount of money it owes) and divides it by the equity the firm has (the portion of the company shareholders own). Usually, the more equity a firm has as compared to its debt, the stronger it is because it doesn't have to pay a lot of interest payments on debt, thereby draining valuable capital. However, if management can employ debt in such a way as to earn more return on the borrowed money than the interest payments on the debt, then there is definitely a benefit to having debt. So some debt can be a good thing. And this ratio will give you a handy measure of how much debt the company has when compared to the equity it has.

For example: if a company has long term debt of $10 million in the form of a bond outstanding and has equity of $10 million, then the Debt to Equity ratio is 1 or 100%. (10/10=1) Long term debt is the only kind that's used in this equation because short term debt, debt owed within one year, is paid from current assets such as cash. If this same company has the bond outstanding and only $1 million in equity, then the Debt to Equity ratio is 10 or 1000% (10/1=10) and this company is in big trouble, not to be considered at the top of your investing list. If the company has the $10 million bond outstanding and $20 million in equity, then you're feeling a little more secure. Then you've got a debt to equity ratio of .5 or 50%.

Each value investor has to determine a comfort level for this ratio. Some don't want any debt on the balance sheet. It makes for one less thing to worry about. However, a company with no debt may not be exploiting a chance to increase earnings by using a small amount to fund projects that will give a better return than the cost of the debt. Again, a little debt can be good for a company's earnings. Too much can be the lead weight on a swimming company that's going down fast.

One more word on Debt to Equity ratios: these are different from Debt to Capitalization ratios which include both debt and equity in the denominator. Be sure you're looking at the Debt to Equity ratio when you're investigating this number.

The Return on Equity Ratio (ROE): In its simplest form, think of it like this: it's the return you're getting by investing in a company. Why? Because the equity is the portion of the company stockholders own, the amount that's left over after all debts have been paid. So when you buy a stock, you become a stockholder and own a portion of the equity. All the stockholders own all the equity. When the company has paid off all its debts and costs of doing business for the year, what's left over is the net income. That net income then is added to the stockholders' equity. So value investors are looking for stocks that have good net incomes as measured by the percentage of equity the net income represents. Sorry, but I had to say that.

Here's the translation: if a company has equity of $10 million and makes a net income of $1 million, then the return on equity is 10% (1/10=.10 or 10%). If it makes $2 million, then the ROE is 20%. That's a level that Warren Buffet is reported to like, the most respected value investor of all time. You might want to use that as one of the criteria for picking your stocks: a minimum of 20% ROE. (Drop this line at your next cocktail party: I look for a minimum ROE of 20%; then ask: What level of ROE do you like? You won't find the bar crowded if you hang out there and use these lines.) Usually, the larger the company, the harder it is to have large returns on equity because it means the large company has to grow even larger. That's one of the amazing attributes of Coca-Cola; it's return on equity has been well above 20% for many years. (Once again, please remember that this is only one number, and you need many numbers to make up a good investment choice.)