7. Debt-to-Capital
Financial leverage can be very dangerous. Those of us who have felt the pains of credit card debt or an excessive home mortgage understand that borrowed money can be a very dangerous thing if we overextend ourselves.
That’s also true for businesses and is a main reason why we look at a company’s debt-to-capital ratio. This financial metric tells us how much debt a company is using to run its business.
If a company has $100 worth of equipment, it acquired that equipment through some combination of debt and equity.
The debt-to-capital ratio tells you what proportion of a company’s financing is from debt. Using the example above, suppose the $100 of equipment was supported by $20 of debt and $80 of equity.
The company’s debt-to-capital ratio would be calculated as follows: total book debt ($20) divided by total book debt ($20) plus equity ($80). The result is a debt-to-capital ratio of 20% ($20 / $100). In other words, debt accounts for 20% of the company’s capital structure in this case.
We prefer to invest in companies with a debt-to-capital ratio no higher than 50%, although some businesses such as utilities can reasonably take on higher debt levels due to the reliability of their earnings.
If a company unexpectedly falls on hard times and has too much debt and interest to pay with its dwindling cash flow, its stock price can get crushed and the dividend payment becomes that much riskier. Companies will always pay their debt obligations before paying a dividend.
8. Net Debt / EBIT
While the debt-to-capital ratio was focused on the company’s capital structure, the net debt / EBIT ratio compares a company’s debt to its earnings.
The idea behind this financial ratio is that a company with a seemingly high level of debt might not be as risky as it appears if it is generating a lot of profits and has plenty of cash on hand.
Net debt is a company’s total debt less the cash it has on hand. For example, if a company had $100 of debt and $10 of cash, its net debt would be $90.
EBIT stands for “earnings before interest and taxes” and is also referred to as operating profit. EBIT is typically measured over the course of one year.
Dividing net debt by EBIT, we can calculate how many years it would take a business to pay off its debt using its cash on hand and annual operating profits.
Suppose PepsiCo, Inc. (NYSE:PEP) had $100 of debt, $10 of cash on hand, and $45 of EBIT last year.
Pepsi’s net debt would be $90 ($100 of debt less $10 of cash). Dividing net debt ($90) by Pepsi’s EBIT ($45) gives us a net debt / EBIT ratio of 2.0.
In other words, Pepsi could theoretically eliminate its debt with cash on hand and two years’ worth of operating profits.
We generally prefer to invest in companies with a net debt / EBIT ratio no greater than about 2.0, but companies with more stable earnings can afford somewhat higher leverage ratios.
Follow Pepsico Inc (NASDAQ:PEP)
Follow Pepsico Inc (NASDAQ:PEP)
9. Price-to-Earnings Ratio
The price-to-earnings (P/E) ratio is arguably the most popular valuation metric used by investors.
The metric simply divides a company’s stock price by the amount of earnings per share it has generated over a one-year period.
Historically speaking, the long run average P/E multiple for the market has been about 15. Companies perceived to have more stable earnings and faster earnings growth potential usually trade at higher earnings multiples than the market.
We generally prefer to buy companies that trade at P/E ratios less than 20 and intend to hold our stocks as long as possible once we buy.
