Tuesday, November 24, 2015

Debt-to-Equity Ratio

Stock-Picking is for Chumps!   Sadly, our current financial system forces us all to be investors, whether we want to be or not.

I have noted time and time again that stock picking is for chumps.   I have most of my invested assets in mutual funds, and they do OK.   I have bought some stocks, and done well with some - mostly conservative blue-chip type of investments.  Stocks for companies that actually make and do things (as opposed to Internet IPOs) and generate dividends and increase in value over time.

Some other stock picks - well, not so good.   Particularly in the early days, when I would do dumb things like watch a financial channel and listen to some "guru" tell me that XYZ stock is going to go up.   And I figured that since he was just telling me (and just a few hundred million other people) this "insider" information, I would be smart to invest in that stock!

Eventually, I stopped doing that.   And I started to ask myself what stocks were all about and what made one worth more than another.   And I realized there are a lot of variables at work, in addition to all the emotional freight.   The latter is how some folks make a lot of money in the market.   Whether it is a teenage boy in suburban New Jersey hyping penny stocks on the Internet, or some Wall Street hot-shot hyping a stock and then dumping it, the effect is the same.   People are sheep, people are uneducated, people are stupid, and people are emotional and all convinced they are going to make big bucks on "the next big thing" so if you drop a hint about some stock, the plebes will go after it like mad, which in turn drives the price up, confirming to the plebes that they made a smart choice.   And then it tanks - like all bubbles do - and they lose their shirts.

That is the emotional aspect of it - or one example, anyway.   The market is full of undue exuberance and pessimism.   Stocks overshoot in price and undershoot as well.  As in any human endeavor, it is not an exact science.

But speaking of science, surely there has to be a way to rationally evaluate the value of a stock, right?   I mean, we can't be party to insider information - the introduction of a new product, or the coming reports of lower earnings, or a pending lawsuit that could cost the company millions.   That sort of thing, unless you had a time machine or inside information, is not available to us. 

But let's assume a company is running a steady-state condition.   Acme company makes widgets, and is not facing a lawsuit by disgruntled customers who find that widgets cut their fingers off.  Similarly, there is no new widget 6.0 coming out next Thursday.  The company isn't about to report a drop in earnings.   Surely, there must be a way to quantify how much this company is worth in real dollars and cents, right?

And maybe there is.  But it ain't easy.   A lot of people use various "metrics" to measure the value of a company.   The obvious things are share price and number of outstanding shares, which when multiplied together, generate this fictitious number called "Market Cap" which as I have noted before, is utter bullshit.   The problem with Market Cap is that it assumes that all shares of a company are equal in value, which they may be, in a buyout situation.   But when purchased initially, each shareholder pays a different amount and values their stock differently.  Some shares (usually the majority with an Internet IPO) belong to insiders who paid little or nothing for them.    And if you sold all those shares at once, well, the stock price would plummet.   So it really doesn't represent a realistic valuation of the company - at least in my opinion.

Things like earnings per share (EPS), dividend per share, Dividend Yield, and Price to Earnings Ratio (P/E Ratio) tell a little more of the story.   Not the whole story, but more of it. 

For example, let's assume ACME has 100,000 shares of stock outstanding at $10 each.  So the company has a "Market Cap" of a million dollars - which may be more than the plant, inventory, equipment, trade secrets, intellectual property, brand, and goodwill are worth - or possibly less.   Market Cap is just a number, and not a very accurate way to valuate anything.

Now suppose Acme earns $1 per share every year (EPS: $1) which means for every share of stock outstanding, they earn (profit) by $1.   Now, for the sake of simplicity I won't go into EBITA (Earnings before Interest , Taxes, and Amortization) which might be an interesting number to look into later on.    That number, as you might expect, will be a lot higher.   Now if earning $1 a share, Acme is pulling in  $100,000 a year in profits, which is about 10% of the company's worth, and that's not a bad performance.

Now, let's also assume the company decides to keep half that money (as retained earnings) and pay out half in dividends, or a dividend of 50 cents a share.   That would generate a dividend yield of 5%, which in this economy would be considered a pretty good dividend.   You buy a share for $10 and you earn 50 cents - in effect 5% interest on your investment.   Since the company is retaining the other half of the earnings, it is assumed the company is now worth 5% more, and the stock price should reflect this.

This also means the company has a P/E ratio of 10 (the price, $10 divided by the earnings, $1) which would be a very low P/E ratio indeed.   Generally, most folks think that a P/E ratio of around 20 or so is nice (a 5% profit) but some wags opine that with certain sectors (read: Internet Stocks), it is OK to have a P/E ratio of 100 or even 1000.

Some folks look at P/E ratio as the number of years you'd have to wait - at that rate of earnings - to make your money back on the stock.   With a P/E ratio of 10, you'd earn back your stock price in 10 years (assuming the price of the stock appreciates 5% a year and you earn 5% dividends in our Acme example).  And that would be pretty good, as most economists say an investment should double in value every 7-10 years, in a normal market.

Linked-In, last year had a P/E ratio of 2092, which means you could live as long a time as from the time of Christ until today, and still not make your money back.   For this year, they are projecting a negative P/E ratio, which of course means they are losing money.   Some stock sites don't show negative P/E ratios, but rather just a "--" meaning the company is losing money.  It depends on the site.  Not all sites report metrics the same way, as we shall see.

So anyway, our Acme Corporation seems to be doing well.  It is making a profit (which they have to pay corporate income tax on).  After all, it is churning out a regular dividend (which is taxed to you as ordinary income) and also retaining earnings which should cause the stock price to going up accordingly (which you will have to pay capital gains tax on, when you sell the stock). 

Note how the same profits are often taxed twice in the United States, once at the corporate level and again at the shareholder level.  The next time a Wall-Street protester whines to you about "Corporations not paying taxes" you might want to point this out to them (and the fact that we are one of the few industrialized countries that double-tax corporations).   But then again, save your breath.  They won't understand the concept because they are predisposed not to.   So just smile and move on.

So is Acme Corporation a good stock to buy?   Well, in addition to the "what ifs" we talked about above (the nature of the market, risk of failures or lawsuits, new products, competition, and so forth) there are other aspects as well.

For example, the management of Acme Corporation might be hollowing out the place with debt.   Management is paid in stock options which allow them to buy company stock at a fixed price, regardless of the market price later on.   So for example, Fred Mertz is the CEO of the company, and when he was hired ten years ago, he was given a stock option at $5 a share, which could be executed five years later (the terms of stock options vary based on a number of terms and who the option is being given to).   So today, Fred can exercise this option, and buy 1,000 shares of Acme for $5 and instantly double his money.  In the real world, of course, the Mertz's make millions of dollars with these options - sometimes tens of millions or more.

So Fred has a big incentive to crank up the stock price.   He has less incentive to crank up the dividend rate, other than how the dividend rate affects stock price.  And there are a number of ways he can spike the share prices.   Buying back stock, as I discussed before, is one way to hike the share price.  If there are 100,000 shares outstanding and the company buys back half of them, then each share is arguably worth twice was it was before - $20 a share.   Fred obviously would like to do this.  But how?  There isn't enough money in the kitty to make such a purchase.

Fred could borrow the money - from a bank, from investors, or by issuing corporate bonds.  He loads the company up with debt, in this case, $500,000 of Acme Corporate Bonds, and buys back half the stock.  Now companies can do this, and as I noted before, there are many ways a company can get funding to operate and buy equipment, etc.  They can issue stock, they can issue bonds, or they can borrow from banks or other lenders.

Stocks are neat in that you can issue stock and you don't have to pay back your shareholders, unless they are expecting dividends over the years.  With a loan or a bond, you have to pay back the lender or bondholder, plus interest over time.   So you can see, debt is a greater burden to a company, as it has to be paid back (just as we have to pay back our debts but we seldom think about that).

The problem with debt, for a company, is that the repayment terms are pretty inflexible.  You have to pay back the loan with X payments over Y years, including principal and interest.  With a bond, it is the same deal - you have to pay interest (in those detachable coupons of yore) and when the bond matures, you have to pay the face value back.   

With stocks, well, you pay the shareholders dividends only if you are making money.  If you hit hard times, well, you might cut the dividend or suspend it entirely.   And you never have to pay back the shareholders what they paid for their stocks, unless you decide you want to buy back stocks, and even then, only at market value, which may be less than what the shareholder paid!

Now to be sure, some companies fold over their debts over and over again into new loans or new Bonds.   They are perpetually in debt, having to borrow to buy new widget-making machines or whatnot.  And unfortunately this creates another risk for the company, as the rates at which you can borrow depend on interest rates (which today are very low, but in the past were as high as 10% or more).  The rates you pay also depend on the perceived risk, so if your company is having hard times, your lenders will ask you to pay more, and that in turn will make your hard times even harder.

For example, Fred has issued $500,000 in bonds and bought-back half the Acme stock.  The interest rate on the loan is 10%.  So every year, he has to pay $50,000 in interest, which is about half their annual earnings.  This sort of cuts into the profit picture.   Moreover, this "leveraging" of the company puts the company at risk - for insolvency and bankruptcy.   If lenders perceive that Fred is not doing a good job running Acme, they may cut off his credit lines.  Bond buyers may shy away from his C- rated junk bonds.  The cost of lending could escalate quickly - to the point where interest expenses start to become some of the largest expenses the company has every year.

Our old friend Mitt Romney was in this business.  They would buy failing rust-belt companies, like old steel mills, which had Hazmat cleanup problems (unfunded) and employee pension and health plans (underfunded) that the current owners just wanted to unload.   They would borrow money in the name of the company they were buying in order to purchase the stock - sort of a snake eating its own tail.   Then they would spin off the liabilities into smaller designed-to-fail companies and then sell off the rest and make a profit - leaving the Federal government with a Hazmat cleanup problem, and retired employees with their pensions cut in half.  And if it all blew up in their face, well, they might walk away with out a scratch, as it was someone else's money anyway.   Or, if they were the bondholders, they could end up as shareholders in reorganization - as the fellow who owned Friendly's restaurants did.   Nice work if you can get it.
And this is where Debt-to-Equity ratio comes in.  As the name implies, it is just a fraction, with the numerator the amount of debt a company has, and the denominator the amount of equity the shareholders have.   It can get a lot more complicated that that, and some folks multiply it by 100 to make it a percentage for some reason.  The link above has a more detailed description of the term.   But generally speaking, the higher the D/E ratio is, the more the company is leveraged with debt.

So, for example, at Acme, we have a debt of  $500,000 and equity (the vaunted "market cap") of $1M, so our D/E ratio is now 0.5 (or 50, if expressed as a percentage) which would be very, very low for many industries.    Of course, shareholders read annual reports (well some of them do, anyway) and they see this debt piling up on the company ledgers.   So they think, "Well, with all this debt, maybe the company is worth less" and the market value of the stock may decline.  Like anything else with stocks, it is not an exact science, and even with this "simple" example, it is hard to quantify anything with certainty.  Of course, if the stock value declines, the fraction gets larger, so the D/E goes up even more.  It can be a vicious circle.

What got me started on this was a small piece of Stock-picking I did the other day (I know, only idiots are stock pickers - I'm an idiot, first class!).   I bought some Ryder stock - not a lot, and thanks to FREE TRADES, a small investor can afford to buy a small amount of stock (e.g., on the order of $1000 to $5000) and thus not risk a lot on any one trade.   Ryder seemed like a good company with good metrics.  The P/E ratio was around 10-14, which is astonishing, and dividend yield of about 2.5% which in this economy is better than what banks are paying.  Since then, however, the stock has dropped about 20% in price, which is kind of depressing.

What is going on that is making the stock worth less (but not worthless)?   Well, although their profits are up, revenue is pretty flat, and they are cranking out dividends like clockwork, their debt-to-equity ratio has been going up during the last year.  Total debt has gone from 4.7 Billion in 2014 to 5.4 Billion in 2015, and I guess the market has noticed this.

Annual reports or quarterly reports are boring to read.   But this little tidbit explains what is going on:
Total debt as of September 30, 2015 increased by $720 million compared with year-end 2014, due to investments in vehicles to fund growth. Debt to equity as of September 30, 2015 was 279% compared with 260% at year-end 2014. Debt to equity increased due to investments to fund growth and foreign exchange impacts. Due to the increase in leverage, the Company elected to temporarily pause the anti-dilutive share repurchase program early in the year. The Company will evaluate resumption of the program in 2016. Total debt to equity was slightly above Ryder’s long-term target range of 225% to 275%; however, this metric is expected to be within the target range at year end. 

So they borrowed more money, to buy new equipment.  But that also meant they had to suspect their stock buy-back program, which was jacking up the stock price a bit.   Note how they show the Debt-to-Equity ratio here as a percentage (279%) versus the fractional value (2.79).   Not only is the D/E ratio important in evaluating a stock, but the trend of the D/E ratio as well.   If the D/E ratio is going up, that may mean more debt on the books.  It may also mean the share price has gone down, as it is a fraction.

If D/E is trending downward, it means the debt load may be going down and/or share price is going up, both of which are good news for investors.   GE, for example - everyone's favorite whipping boy - has seen its D/E ratio go from over 4.0 to about 2.2 today.   And not surprisingly, the stock has been going up in value.  Arguably this is a good trend.

So, does this mean Ryder is in trouble?  Should I dump my shares and take a loss?   Or double-down my bet and buy more?   Well, this is where stock picking becomes more like gambling.   Maybe not so much as in playing roulette, but more like picking the ponies - trying to divine from bloodlines and racing history what is going on and how is going to win.  With a very low P/E ratio, solid profits (that seem stable anyway) and new investment in hardware, some analysts are predicting that the company will prosper even further in 2016.   And perhaps also, the market has over-reacted to the drop in share price.   Some people, when they see a stock dropping, will sell, which drives the stock price even lower.

And debt can serve a purpose.   In this case, they claim the debt is being used to purchase new vehicles, and over time, these new vehicles will generate new revenue, which in turn will generate more profits and help pay down debt.   The report goes on to further state their leasing business is increasing, with deliveries of leased vehicles (that they buy) in 2016.   So perhaps this is where some of the debt is going.

I guess we'll have to wait-and-see.

By the way, the D/E ratio and its trends are not always readily visible on most financial sites.  Most site hawk the share price and its trends - as if anything could be divined about the health of a company from share price alone.   Some of the better ones show P/E ratio and Dividend Yield.   But you may have to search on "Acme D/E Ratio" to see charts of the trends.

And yes, you may have to actually read the company's quarterly and annual reports, as boring as they are.

Like I said, stock-picking is for chumps.   And it can be a painful learning experience!