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The hardest part of your voyage to becoming a better investor is learning to separate key data from minutiae. If you follow the markets, there are thousands of investing metrics: some mostly important, a few mostly useless, but most fall into the third category of conditionally important. The problem, then, is when a metric is treated as always important when it really should be considered situationally important.

One of the metrics mentioned quite frequently is the debt-to-equity ratio. Usually during an interview, a bearish analyst will mention the reason his/her firm is avoiding a stock. More often than not, the analyst will include an increase of the debt to equity ratio as a supporting metric in their investing thesis. So much so that investors have been conditioned to think of an increase in a company's debt-to-equity ratio is always negative. That's not true.

Asset financing 101

In order to generate future growth, a company needs to invest in assets. How a company chooses to finance assets is called the capital structure decision. In a nutshell, there are three ways a company can finance assets. According to pecking-order theory, managers prefer to finance assets by the following methods:

  • Earnings (internal financing)
  • Issue debt
  • Issue equity

In a perfect world, a company would be able to finance future assets from earnings, but in reality this is not always feasible. Remaining options are to finance the assets with debt or issue equity. We'll focus on these options and their effects on the debt-to-equity ratio.

Before we begin, it's important to understand the debt to equity formula. It's actually very simple:

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Holding all other factors constant, an increase of debt will most certainly raise the debt-to-income ratio. However, financing assets by issuing more shares of stock is generally considered always a negative for investors, as it waters down their ownership, but would actually lower the debt to equity ratio.

Other reasons for increasing debt

Over the last four years or so, Apple (NASDAQ:AAPL) has increased its debt to equity ratio (long-term debt, current portion of long-term debt, and commercial paper) from 0 to .61. The rule of thumb heuristic is 0.6 approaches a high debt-to-equity ratio that would make it difficult to borrow money but it's not been a problem for Cupertino. What exactly did Apple do with the debt proceeds? Mostly pay dividends and buy back shares stock and retire it.

That was part of the plan, however. With interest rates on debt at historic lows and the company unable to tap the vast majority of its earnings due to tax domiciling issues, Apple decided to lower their cost of capital by taking on debt and using the proceeds to repurchase shares and pay equity investors cash dividends. It's not just Apple, many companies have taken advantage of the debt markets and used the funds to retire debt. This pushes up important investing metrics like earnings per share at the expense of an increased debt-to-equity ratio.

The debt-to-equity ratio is important sometimes, but this is a better metric

To be fair, there are cautionary tales for companies that have increased their debt-to-equity ratios. One that quickly comes to mind is Valeant Pharmaceuticals (NYSE:VRX), which saw its debt-to-equity ratio climb under former CEO Michael Pearson. However, the real story was the company's strategy of buying overpriced assets with the debt proceeds and relying on rent-seeking price increases and regulatory arbitrage in order to monetize these assets.

The problem with the debt to equity ratio, then, is it is not interpreted in the context of capital structure or corporate strategy and it should. Even worse, an increase in the nominal debt value has nothing to do with the ability of a company to service its debt. That's why a better metric to gauge an organization's debt strategy are coverage ratios: the two most noted are the debt service ratio and the interest coverage ratio. Personally, I prefer the latter because the debt service ratio includes principal repayments/bond redemptions in addition to the cost of servicing the debt (interest expense).

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The Interest Coverage ratio is simply the earnings before interest and taxes divided by interest expense. Considering the investor-desired figure is in the numerator, a higher interest coverage ratio is better. Currently, Apple's interest coverage ratio is nearly 70 times whereas Valeant's ratio is 0.6. Essentially this means Valeant is currently not generating enough in earnings before interest and taxes to pay their creditors.

More broadly, though, Apple shows judging a stock on its debt-to-equity ratio can be misleading. If you'd like to incorporate this into your analysis, fine, but don't assign too much weight on this metric.

 

Jamal Carnette owns shares of Apple. The Motley Fool owns shares of and recommends Apple and Valeant Pharmaceuticals. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. 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.