Debt to equity measures the amount of debt company has in proportion to its equity. It is calculated by dividing all debt by all equity. A D/E Ratio is usually expressed as a number, although it can be shown also in percentage points.
Debt/Equity Ratio = Total Liabilities / Shareholders Equity
Debt to equity gauges how the company leverages its running business. It shows how much of loans the firm has taken to run its operations. When the ratio is higher, the company has more liabilities and thus, this affects the earnings results due to interest expenses. Even though higher D/E Ratio is considered as a riskier choice when selecting the stock, it doesn’t necessarily lower the earnings at the end. If the company uses the loans effectively and efficiently, it may generate even more profits.
Debt/Equity Ratio is a valuation indicator and thus, it must be used among the stocks within the same industry. The nature of company business model varies across the sectors, for instance, a construction company is going to have different ratio levels than a bank.
In a search of a good quality trend, a higher debt to equity ratio is not really favorable. Even if the company can leverage well, there is still too much risk in future and thus, a possibility of earnings volatility may jeopardize an entire trend channel.
The stocks with D/E ratio less than 1.0 perform the best. A probability of future stock price increase is much higher with the stocks of the ratio below 1. In the leading sectors like technology, the best performers with trendy behavior pose a ratio below 0.5.
Note, the Debt to Equity ratio must not be used as the only indicator when picking the stock. It must always be accompanied by other fundamental indicators since there are also other aspects of the firm’s engine that drives profitability and valuation.
The useful fundamental indicators that are commonly used together with D/E ratio are ROE and ROIC.