Monthly Archives: August 2008

The fourth part of this series deals with the debt/equity ratio, which is another key component of Warren Buffett’s legendary methodology. In fact, it is a component that the man himself treats very carefully when deciding which stocks to invest in. Just like the return on equity in the previous part of this series, it is an equation that is commonly used in finance, however, Buffett is the one who makes the most and greatest use of it.

The components that make up the debt/equity ratio are fairly obvious and I’m certain that many people first heard of it in high school in a commerce or business class. But just in case, there’s still some confusion, I will give a quick, brief explanation. The debt/equity ratio is given by total liabilities of a company divided by shareholders’ equity.

Both total liabilities and shareholder’s equity can be found on a company’s balance sheet (sometimes known as the statement of financial position). This is known as taking its ‘book value’. On the other hand, if the concerned company’s debt and equity are publicly traded, you can use the market value instead. There is also the possibility of using a mixture of both the book and market value.

The ratio displays the percentage of equity and debt the company is employing to finance its assets, and a higher ratio indicates that debt is principally propping up the company. The major complication with possessing a high ratio (which indicates a high level of debt when compared to equity) is that it tends to make earnings volatile and be the subject of large interest expenses.

In fact, Buffett takes the results of this ratio very seriously and it’s very educational to comprehend the reasons why. Like all investors, he wants a company to only possess a tiny quantity of debt and the reason why is that a tiny quantity of debt indicates that growth in income is being yielded from shareholders’ equity contrary to borrowed money. If a company utilises borrowed money to finance its income, this usually forms a vicious cycle of debt and repayments which is unstable and which is dependent on interest rates.

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 fifth and final section of this publication will concentrate on one final component of Buffett’s methodology known as profit margins. Coming soon!

In making determinations as to what the stock markets worldwide are going to do in terms of how prices move, there are two distinct schools of thought about analysis of companies and their investment prospects. The typical school of thought, and one that has been successful over the last decades has been the school of fundamental analysis.

This type of analysis looks at the financial prospects of a company, and then looks at their chances of achieving desirable results compared to its competition. On the other side of the fence, there are some in the school of thought involving technical analysis, a largely unscientific but seemingly successful school of thought as well. So, what exactly is the connection between technical analysis and stocks?

If you can believe it, technical analysis is simply the studying of past market trends to make a determination as to what the future of the stock’s price is going to be. But, that still doesn’t answer the whole question – what is the whole connection between technical analysis and stocks? More importantly, how can people think they can predict the price of a stock from looking at charts and graphs and not the financial health or condition of a company?

Well, part of the reason that technical analysis is utilized by some market analysts is that, although one would think that statistically speaking a trading day on the stock market should only be influenced by that day’s events and treated like an independent event, the reality is that most market movement trends over time and the full impact of one event (a downgrade of the stock by an analyst or a movement of earnings higher than expected by the same analysts) is never isolated to one day.

As a result, technical analysis utilizes tons of data including old stock quotes, trading volume charts, and a host of other data, to develop charts and graphs that work to determine exactly how long the impact of a move in a company will persist and impact the stock market trading of a particular issue.

In many cases, a side by side comparison of a fundamental analysis and a technical analysis of the same stock market issue have yielded results in which the technical analysis has been more able to predict the short term ebbs and flows of a particular company. However, the fundamental analysis works on a longer term basis, and so the technical analyst has earned a reputation of being a \”short\” predictor rather than a \”long\” predictor in the markets.

Technical analysis is much more difficult to explain to the layperson due to the incessantly large amount of jargon involved, much of it to describe shapes in graphs and trend lines that exist. An elbow, or a shoulder, or a host of other terms can all be used to describe the same trend in a graph (in this case, a level market, followed by a steep drop, and another leveling off) which can confuse and put off the typical investor from investing in a company.