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The Power of Ratios For Successful Stock Investing

by: MartinSejas
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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 of these are freely available on a company's balance sheet (sometimes called the statement of financial position). Taking these numbers from these reports is known as taking its 'book value'. On the other hand, if the debt and equity of the interested company are traded publicly, you have the option of using the market value instead. In addition, you may also choose to use a mixture of both the book and market value.

The ratio displays the percentage of equity and debt the company is employing to finance its assets, and a higher ratio indicates that debt is principally propping up the company. The major complication with possessing a high ratio (which indicates a high level of debt when compared to equity) is that it tends to make earnings volatile and be the subject of large interest expenses.

In fact, Buffett takes the results of this ratio very seriously and it's very educational to comprehend the reasons why. Like all investors, he wants a company to only possess a tiny quantity of debt and the reason why is that a tiny quantity of debt indicates that growth in income is being yielded from shareholders' equity contrary to borrowed money. If a company utilises borrowed money to finance its income, this usually forms a vicious cycle of debt and repayments which is unstable and which is dependent on interest rates.

The lesson to digest from Buffett is to focus your efforts on companies that have a low ratio, or at the least a ratio which is low compared with other firms in the same industry. All that's needed from your part is to calculate the ratios for each company, but as I pointed out previously, the necessary information is often available on company reports.

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 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!

About the Author

Author Martin Sejas is the owner 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 Internet.

The Power of Ratios For Successful Stock Investing

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