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Debt-to-Equity Ratio - How It Works and How Investors Can Use It

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When it comes to the stock market, sometimes you might hear the term "debt-to-equity ratio" mentioned. It refers to a fundamental analysis metric that is popular among active stock traders.

This article will explain what a debt-to-equity ratio is and how investors might be able to benefit from using it.

 

What Exactly Is a Debt-to-Equity Ratio?

A debt-to-equity ratio is a fundamental valuation metric used in the stock market to evaluate a company's financial health.

It looks at how much debt a company has in relation to its equity. It can be a helpful measure of the financial risk a company faces.

The formula looks like this:

Here is a breakdown of the components of the calculation:

Total Liabilities: This includes both short-term and long-term debt obligations of the company.

Shareholder Equity: This is essentially the net worth of the company, calculated as total assets minus total liabilities. This is also referred to as the book value of the company.

The company's total liabilities and shareholder equity can be found on its balance sheet, which is publicly available for companies in the stock market.

 

Why Does a Debt-to-Equity Ratio Matter?

Debt-to-equity ratios can be seen as a metric to gauge how much financial risk a company faces at any given time. Here is a breakdown of what different debt-to-equity ratios might signal about a company's financial health:

Less than 1: If a company's debt-to-equity ratio is less than one, it means that the company has more equity than debt. This can be perceived as a sign of financial strength, suggesting the company might not be overly dependent on borrowed funds.

Equal to 1: If a company's debt-to-equity ratio equals one, it indicates an equal level of debt and equity in the company's capital structure.

Greater than 1: If a company's debt-to-equity ratio is greater than one, it indicates that the company has more debt than equity. This suggests a higher level of financial risk since the company has substantial obligations to pay off debtors.

For stock market investors, knowing a company's debt-to-equity ratio might be one factor in their analysis to ensure they are aware of the financial risk a company is facing.

It's important to note that average debt to equity ratios can vary quite a bit by industry. For example, utility companies might have high debt-to-equity ratios as a normal part of their business operations, while software companies might have very low debt-to-equity ratios.

 

How Do You Find Stocks With Low Debt-to-Equity Ratios?

You can find them by using our Low Debt-to-Equity Ratio scanner. It's a free tool we offer here at Stock Market Guides. It uses our proprietary scanning technology to find stocks that have low debt-to-equity ratios.

Here's how the scanner results look:

 

That tool ensures that you don't have to waste time flipping through stock profiles manually to find stocks with low debt-to-equity ratios.

 

Can a Debt-to-Equity Ratio Be Negative?

A negative debt to equity ratio can be an indicator of significant challenges for the company. If that ratio is negative, it likely means the company's shareholder equity is negative.

If a company has negative shareholder equity, that means that its total assets are less than its total liabilities. In other words, if an investor were to sell every asset of the company, there wouldn't be enough money to repay all the company's debts.

An investment in a company with a negative debt-to-equity ratio might carry substantial risk.

 

Example of a Debt-to-Equity Ratio Investing Strategy

For this example of a debt-to-equity ratio investing strategy, we're going to look for stocks with low debt-to-equity ratios and plan to hold them for up to a year.

 

 

In particular, we'll look for stocks with a Debt-to-Equity ratio below 0.75.

Our research suggests this simple strategy might have a track record of success.

 

Entry for the Debt-to-Equity Ratio Investing Strategy

The entry for this Debt-to-Equity Investing Strategy will be as follows:

The entry criterion for our debt-to-equity ratio investing strategy is very simple.

Exit for the Debt-to-Equity Ratio Investing Strategy

There are a lot of possibilities here for the exit.

For any given investing strategy, it can be helpful to define two different criteria for the exit: a profit target and a time limit.

Not everyone sets exit criteria for a long-term investment, and that's totally fine. Ultimately, you are in charge of your investments, and you can manage them any way you want. But for the purposes of this investing strategy example, we will define them:

 

1. Profit Target

We will set a profit target that would reflect a 15% gain if the position were to be sold at that price.

In other words, we will take the price we paid for the stock at entry, multiply it by 1.15 (which effectively adds 15%), and use that to set up a sell limit order as a profit target.

If the sell limit order gets filled before the time limit is reached, then our investment is complete, and we will have realized a 15% return on investment.

2. Time Limit

We will set the time limit as one year. If the stock has not hit the profit target within one year of the date of stock purchase, then we can close the trade manually at the stock's prevailing price.

 

How Well Do Low Debt-to-Equity Ratio Investments Actually Work?

The idea of a low debt-to-equity ratio investing strategy sounds nice to many people because it offers a clear, easy-to-understand way to find an investment idea.

But does it actually work? Can traders indeed generate profits from buying stocks that have low debt-to-equity ratios?

That's exactly what our company can help answer for you, since our scanner technology has allowed us to do our own research on that precise question.

The answer is that investments based on low debt-to-equity ratios are not always profitable, but for certain stocks they might indeed have a track record of success according to our backtest research.

Here is some data that shows how a proprietary low debt-to-equity ratio investment strategy we created has performed historically according to backtests:

 

 

Anyone who signs up for our stock scanner service will be able to see stocks that qualify for that trading strategy in real time.

 

Learning More About Debt-to-Equity Ratios

You can contact us any time if you would like to ask any questions about debt-to-equity ratios or anything else related to the stock market.