Free Articles at Neutron Marketing Article Publishing and Distribution » Finance » Stocks-mutual-funds » The Most Important Ratio In Value Investing
Previous Article - More About Darlene Nelson, Trading Instructor
Next Article - Can we really make money through stock trading?

View PDF | Print View | Html Version
by: MartinSejas
Total views: 3
Word Count: 529

The 4th installment of this publication concerns the debt/equity ratio, another major cog of Warren Buffett's classical investing strategy. In reality, it is an element that the master himself deals with very cautiously when it comes to decide which stocks to put money in. Similar to the return on equity in the 3rd installment of this publication, it is an formula that is typically employed in finance, nevertheless, Buffett uses it more effectively that anyone else.

The debt/equity ratio is made up of 2 obvious parts and it's almost certain that everyone has come across the term some time in their lives, whether it be at school or at another educational institutions. However, some people may not be too familiar with the term, which is why I will now explain it. The debt/equity ratio is equal to total liabilities being 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 illustrates the proportion of debt and equity the company is utilising to support its assets. If a ratio is high, this corresponds to a situation where debt is mainly shoring up the company. The principal dilemma with a high ratio is that it renders earnings volatile and leaves it at the mercy of interest rates, which can be expensive.

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.

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.

Some investors use only long-term debt instead of total liabilities in the calculation of the ratio. This could prove to be more useful and convenient as investing in stocks is for the long-term not the short-term. This is not just my own personal view, but Warren Buffett's own way of thinking.

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 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 mission is to become the 'one-stop shop' on the best stocks trading websites and programs on the Internet.

---

Rating: Not yet rated

--Choose-- 0 1 2 3 4 5

No comments posted.

Add Comment

Enter the code shown