How Much Debt Does the Company Have
I am very objective about my financial journey and keep reminding myself that my future depends on the decision I make today. Not just my future, it’s also my families future. With this reminder, I do not ever take reckless financial decisions that may jeopardize my financial goals. And I choose to invest in companies that are the best of the best. After I look their their earnings track record, which I want to see consistently growing, I will then make another filter.
Just in case you arrive here without looking at the previous criteria, please check out our first filter we use which is on earnings.
As promised, I will keep this as simple as possible without going into financial jargons. But you will have to work with some key ratios (even if you don’t understand that’s all fine) which are readily available.
Invest in Companies that Have Little or No Debt
So the next rule is to filter and invest in companies with little or no debt. Why might this debt thing be important? It’s important and simple because any companies with plenty of debt is not so attractive to me. There are probably plenty of reasons why debt is no good but for me I think it will impact earnings or profitable of a company.
Logically, if a company has loans, it will have to use its profit to pay for the loans and whatever left over is then consider as company profit by the end of the year. Paying off loans means taking profit out. Moreover, it can also hurt a company cash flow or financial strength. Anyway, simple logic… debt means less profit to the share holders or investors. So it’s best to stay away from these type of companies.
Paying Off Debts Hurt Companies Bottomline Profit
Of course, please don’t get me wrong. On a personal level, I love loans. Good debts will amplify by investment returns. Of course bad debts will do plenty of damage on your personal finance. So be careful here… To read more on Good debt and Bad Debt, I highly recommend Robert Kiyosaki’s Books. They are just simply awesome and many of my financial learnings and thinking originated from his teachings.
However, as a value investor, I do not want a company with debts regardless if it’s good or bad debts. It’s no good for me and you as investors when profit get eroded by interest payments. This rule has kept me on the right track for the longest time. It’s an easy rule and it’s really easy to screen for companies with little or no debt.
With simplicity in mind, you just need to look at financial summary for a key ratio that is called DOE. When I was in the IT industry, DOE was always referred to as Dead on Arrival which describes that a computer system has arrived Dead…On…Arrival. HA!
The Lower the D/E Ratio the better it is
Anyways, back to value investing, DOE is the acronyn for Debt Over Equity. What I like to see is a company with a DOE of less than 0.5 for it to qualify a place in my watch list. So let’s make some sense of this number. DOE of 0.5 means that the debt is $1 and stock holder equity is $2. Hence you get 0.50 which means you have 2 times the equity over debt and that’s a healthy position to be in. To bring this to our personal level, it just means that you have a loan from a friend that’s outstanding for $1. But you have $2 in your bank account. Is this healthy position to be in? Yeah… we can live with this debt condition. As much as possible, we will aim for ZERO or no debt but it’s going to be rare.
This is one important filter to use but it does NOT mean we rely only on this DOE alone to make our all important financial decisions. It will have to be combined with other criteria before we come up with companies that we want to invest. Remember… 14000 stocks to choose from in United States alone. Why settle for something that we don’t quite like?