Sunday, December 4, 2011

DEBT to EQUITY RATIO

English: Diagram illustrating the relationship...Image via Wikipedia
            This is the fourth of six analyses I have made of the fifty two companies that make up our 2011 Dividend Machines.   First we determined if we met our goal of selecting companies that paid at least a three percent dividend (see post .)  Our next analysis tested our success at picking companies that not only paid at least a three percent dividend but also provided annual dividend increases (see post.)  The third criteria for a company to be considered a Dividend Machine is earnings that are greater than the amount paid in dividends and we analyzed their EPS (see post.)  The final hurdle each company had to meet is a debt to equity ratio of 1 or less or equal to the industry standard.  This post will concentrate on D/E ratio analysis.

            You know that I believe in simple investing.  I believe that to be good income investors you have to devote some time to researching the companies you want to buy and some time analyzing how you did.   But I know from years of working with individuals and companies that a too complex data system leads to research fatigue and poor results.   This is why I used only four, easy to access criteria to find companies that qualify as Dividend Machines.

            Although our top priority as income investors is income, we also want some safety or risk aversion.   You have no idea how many formulae are used to determine the safety of an investment.  I had to find the one piece of data that I feel helps to eliminate ninety percent of bad companies.

            The technical definition of the D/E ratio or debt to equity ratio is simply to add up all of a company's liabilities (bills & expenses) and divide it by the value of the shareholders ownership position.   D/E is therefore a measure of leverage.  Leverage as we know is money borrowed.   Some companies could not get started without quite a bit of debt.  For instance building airplanes or cars, building a utility, creating an oil drilling or refining company are capital intensive businesses. Other companies like a software company or social media company may need no debt at all to get started and to become successful.     In our fifty two Dividend Machines we have them all. 

            One of our goals in buying Dividend Machine companies is we do not want to buy one that is going to go out of business due to too much debt.  We are willing to suffer through stock price ups and downs in favor or income.  But we are not willing to trade income for so much risk that our company may go out of business. 

            Of course D/E ratios change as companies add debt or pay down debt and as they increase or decrease shareholders.  I used the published D/E ratio on Friday, December 2, 2011 for my analysis.

            Let’s start with the bad news and work toward the good news.  One company Lockheed Martin (LMT) D/E ratio has significantly increased since it was first profiled see post.   Currently LMT has a D/E ratio of 2.39.  While that number may not seem our of line because LMT is in a capital intensive business, but two similar companies that are also in our list of Dividend Machines, Raytheon (RTN) see post and Northrop Grumman (NOC) see post have D/E ratios of just .33.   Therefore, to avoid risk I would reevaluate my zeal for LMT in preference for RTN or NOC.

            Eleven companies (ATO, GIS, HAS, POR, SCG, SO WM, WPZ, XEL and BCE) have D/E ratios of greater than one.  Several of these are in capital intensive businesses and more analysis is probably not needed.  But two of these, GIS see post and HAS see post, suggest more scrutiny.   General Mills (GIS) seems suspicious to me.  How much does it cost to get started making cereal?  Yet, Kimberly Clark (KMB) also a consumer staples company has a D/E ratio of greater than one.  I doubt if either of these companies is going to go under because of debt but why not use Johnson and Johnson (JNJ) with a D/E ratio of only .30 or Proctor and Gamble (PG) with a D/E ratio of only. 47 to be our consumer staples companies. Regarding HAS, no other toy maker meets the criteria to be categorized as a Dividend Machines and more than one has high debt.   HAS should be watched over time to make sure it continues to perform in the future as well as it has in the past.

            Sixteen companies have D/E ratios of between .50 and 1.00.  These companies are RPM, RSG, UVV, TU, T, SYY, NJR, MGRC, LEG, ED, DUK, DRI, ABT, AG, YORW, and MSA.

            Twenty one companies had debt but their ratios are less than .50.  These companies are CFR, COP, CVX, GPC, HGIC, INTC, ITW, JNJ, LDR, MCHP, MPR, NHI, NOC, PG, SON, TRI, TRV, UTMD, RTN, and WSO.

            Finally we have three companies, WHG, ESP, and PBI that are debt free.
              Remember we are not measuring the risk of stock price fluctuations.  We are measuring risk as the risk that your investment goes to zero.  Look at each of your income producing investments and know the D/E ratio.  Make adjustments as needed.

            I will perform two more areas of analysis of our 2011 Dividend Machines before I commence our 2012 Dividend Machines project.  One analysis is diversification which will come next.  My last analysis will be …scoff… portfolio performance as measured by stock price. Stay tuned!

Very Truly Yours,

TheMoneyMadam
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