One of the factors I consider in picking stocks for my deep-in-the-money options trading system is debt. It's a primary consideration in my system, which has a win record of 95-1. Big debt doesn't rule out a potentially good stock pick, but it doesn't help. Several debt ratios put a company's leverage into perspective. Debt-to-equity ratios have ramifications for a company's ability to raise credit and keep interest expenses low.
We can measure debt to equity in several ways. One of the simplest ways excludes short-term obligations. The ratio of long-term liabilities to shareholder equity helps us evaluate whether a stock is able to support its debt going forward. The higher the long-term liabilities-to-equity ratio, the lower the bond rating. And a rating reduction forces companies to pay higher interest rates. You can calculate the ratio by subtracting current liabilities from total liabilities -- which are found on the balance sheet -- and then dividing by total shareholder equity. What you get with this ratio is a measure of how leveraged a company is. A highly leveraged company carries a greater risk it will default on its debt. How much debt a company can sustain varies by sector. Industries with highly stable revenue streams -- such as utilities -- tend to carry a lot of debt safely. A measure of 1.0 means a company's liabilities equal its equity value. The safest ratios fall far below 1.0. Microsoft ( MSFT) historically carries little or no debt. At the end of December, its long-term liabilities to equity measured 0.22. Its long-term liabilities included $7.6 billion of "other liabilities," such as legal reserves and tax contingencies. None of Microsoft's long-term liabilities were debt.
Once we know how leveraged the company is, we should compare the ratio to a year earlier, or perhaps just the prior quarter, in order to gage whether the amount of debt the company can support is under stress. A ratio that is climbing in this market could spell trouble for a company's bonds and stock. Now let's look at some examples. Lexmark International's ( LXK) ratio moved up to 1.47 at the end of 2008, from 0.95 in September. Long-term liabilities rose while equity shrank 23%. The worsening situation will cost Lexmark: Standard & Poor's lowered Lexmark's corporate credit rating last week to BBB-, from BBB. On Monday, Micron Technology ( MU) was dealt a rating reduction to B- on its senior unsecured debt by S&P after the company took out a secured loan. Its last debt-to-equity numbers showed the warning signs. The ratio had been 0.79 in February 2008 but rose to 1.01 by December. Should Micron default on the unsecured debt, holders now can expect to recover only 10% to 30%, according to S&P Ratings. This recession is also showing up in the numbers of retailers. At the end of January, Target ( TGT) became highly leveraged with a ratio of 1.45, from 1.14 a year earlier. Not only did long-term debt rise 15.6% year over year, but shareholder equity took a hit, dropping 10.4%. In contrast, Wal-Mart ( WMT), which has capitalized on penny-pinching consumers, maintained a stable ratio year over year at about 0.6 at the end of January.
The drop in consumer spending has also whipped manufacturers of big-ticket items. Whirlpool's ( WHR) ratio rose to 1.65 in December, from 1.03 just three months earlier, as total shareholder equity shrank some 24%. S&P lowered the credit rating on WHR's unsecured debt to BBB- in January. Finally, the U.S. auto industry is the poster child for debt-laden companies. The numbers were already quite bad for Ford ( F) in March 2008, when the automaker's long-term liabilities-to-equity ratio was in big, whole numbers - at nearly 31. Yet Ford still commanded $8 a share in May. But when the company's equity value moved into negative numbers in recent quarters, the ratio became meaningless and Ford became a penny stock. The company announced a debt restructuring last week, which S&P considers to be "tantamount to a default." So keep tabs on excessive leverage by calculating a stock's debt-to-equity ratio. Lenny "Nails" Dykstra, a guy who's used to winning, consistently profits from his deep-in-the-money options calls. You can, too, with his Nails on the Numbers. Try Lenny's service free and see how it works for you. If you decide to subscribe, just one winning call will pay for a whole year!