Leverage and Your Portfolio
Jamal is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It is apparent when I read financial publications, listen to financial news, or even discuss finance with friends that leverage is the most misunderstood concept in finance. We have all heard the popular refrain “this is a solid, debt-free company,” or “this company has too much debt for my liking.” The problem with this line of thinking is that it is myopic. Debt used correctly can be an effective part of capital allocation.
Debt and Capital Allocation
As funny as it sounds, I think many people misunderstand the goal of a business. Most people will say that the goal is “to make money.” Although this is technically correct, we should look into how companies make money. Basically, they acquire goods (assets), and through labor, turn those assets into higher valued products to be sold. Now, that is a really rough definition and doesn’t technically include services businesses, but for the remainder of this post this definition works.
Businesses face choices on how to pay for the actual assets they need to acquire, they can either reinvest profits (retained earnings), sell ownership in the company (equity issuance), or take loans (debt issuance). A good manager will determine the correct mix of financing that provides his or her company with a sustainable competitive advantage.
Ratios
So, a business faces choices; but how do we quantify those choices to determine well-performing companies? In short, what companies are successfully using debt to finance operations? The visual below gives three excellent ratios to measure a company’s use of debt.
Debt to Equity
The Debt to Equity ratio is a measurement of how levered a company is. A company that has a higher debt to equity ratio than peers should be looked at more critically. However, many industries have operated with high debt to equity for years and have used leverage effectively.
The Virginia-based utility company, Dominion (NYSE: D), has shown itself to be remarkably consistent in its debt to equity ratio. In addition, it has rewarded shareholders handsomely, and bounced back quickly from the financial crisis of 2008. The company also has a huge moat in the form of a government-mandated barrier to entry in its operations.
It will be interesting to see how the company finances repairs from Sandy. However, management has been quite adept at financing operations in the past. This is important for management in the utility industry because they generally have dependable revenue, but lower profit margins than other businesses.
Return on Equity
Return on Equity is a measurement of how much profit a company derives from the money shareholders have invested in it. Companies that have high debt to equity ratios typically have a higher return on equity because they have chosen to finance assets with debt, instead of equity. A company that has a very high return on equity is the Michigan-based cereal company Kellogg (NYSE: K). This is due to its large debt to equity ratio (3.89) that allows the company to buy assets with debt financing, not equity. This does present operational risk, clearly outlined by Kellogg in their 2011 annual report.
We have a substantial amount of indebtedness.
We have indebtedness that is substantial in relation to our shareholders’ equity. As of December 31, 2011, we had total debt of approximately $6.0 billion and total equity of $1.8 billion and expect to incur an additional $2.0 billion in debt to consummate our pending acquisition of the Pringles® business from Procter & Gamble Co.
The company has managed high debt to equity ratios in the past, has dependable revenue from its core portfolio of products, and is acquiring debt to finance higher growth brands. Management obviously knows how to allocate capital correctly. In addition, Kellogg has the tremendous moat of a well-known brand that has endured for over one hundred years.
Interest Coverage Ratio (Times Interest Earned)
The last ratio is one of the most important; it measures when debt is becoming too high. The interest coverage ratio measures a company’s annual earnings before interest and taxes (EBIT) divided by its annual interest expense. Anecdotally, numbers below 1.5 are considered worrisome, and numbers below 1 mean a company is not making enough revenue through operations to pay its debt. The problem with debt is that is has a superior position in claims in the event of bankruptcy and must be paid, regardless of if operations are producing enough revenue to do so.
Arch Coal (NYSE: ACI) is a prime example of a company that is burdened with debt. In addition, it doesn't look like the company has an answer to lower natural gas prices and is experiencing a shrinking profit margin. Even worse, the coal industry appears to be more interested in politics than addressing its competitive disadvantages. Until management can produce a plan to address this new reality in energy, this stock is a definite sell.
Foolish Conclusion
As previously stated, debt can be a powerful tool in capital allocation that allows companies to create large returns for its shareholders. It is important, however, to understand how companies are utilizing debt to create competitive advantages. Kellogg and Dominion are utilizing debt to finance upgrades, and have large moats. They are strong buys, and should have a prominent place in your portfolio. Arch Coal, on the other hand, seems to have a deteriorating moat and debt servicing problems. Even worse, the industry appears to not understand its challenges. Avoid Arch Coal at all costs.
jcareagle has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Dominion Resources. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
