12-15-2013, 10:09 AM
A company's debt must be considered in evaluating a stock for purchase. I have seen blog articles and recommendations where a fixed debt to equity level is used as a limit for purchases. The recommended levels have been 0.5, 1.0, and 2.0.
The problem with using debt to equity is that this ratio is usually based on book value. With old plants, the book value will be very low, which can make the debt look worse than reality. An extreme case is CLX. CLX must not have updated its equipment in 50 years, since the book value is extremely low and the debt to equity ratio is extremely high; however, the debt per share is much less imposing.
The way I have been evaluating debt is to assume that all the debt was transformed into equity. This is the way many REITs survived the Great Recession. Obviously, this would dilute the share value.
I implement this concept in two ways. First, share purchases have a hard limit that the amount of debt per share can not exceed the share price. Second, an adjusted stock yield is calculated based on the debt per share (adjusted yield = dividend divided by price plus debt per share) which is compared to the average corporate bond yield as part of the valuation process. Adjusting for debt greatly improves the correlation between income stocks and corporate bonds.
How do you handle debt in evaluating stocks?
The problem with using debt to equity is that this ratio is usually based on book value. With old plants, the book value will be very low, which can make the debt look worse than reality. An extreme case is CLX. CLX must not have updated its equipment in 50 years, since the book value is extremely low and the debt to equity ratio is extremely high; however, the debt per share is much less imposing.
The way I have been evaluating debt is to assume that all the debt was transformed into equity. This is the way many REITs survived the Great Recession. Obviously, this would dilute the share value.
I implement this concept in two ways. First, share purchases have a hard limit that the amount of debt per share can not exceed the share price. Second, an adjusted stock yield is calculated based on the debt per share (adjusted yield = dividend divided by price plus debt per share) which is compared to the average corporate bond yield as part of the valuation process. Adjusting for debt greatly improves the correlation between income stocks and corporate bonds.
How do you handle debt in evaluating stocks?