Last Updated February 24, 2014
For each company you might invest in there is some prudent and optimal amount of debt that it can carry. Taking on some debt makes sense because many companies can generate more earnings from investing borrowed money (in a new factory for example) than they’d have to pay in interest.
But if earnings dry up because of an economic downturn or increased competition, the interest on the debt still has to be paid whether or not the company can afford it.
There is a sweet spot between having no debt, which is safer but comes with an opportunity cost of reduced profits, and having too much debt, where profits can be boosted but only with a significant risk of cash flow problems in the future.
Unfortunately there is no magic number, no single ratio, which shows in simple terms the optimal amount of debt a company should use.
Some investors like to look at interest cover, where current earnings are compared to interest payments. Others like to look at gearing, where borrowings are compared to assets.
Personally I was never happy with any of the standard debt ratios, so I invented my own.
The debt to future earnings power ratio
The main problem I have with existing debt ratios is that they take a short-term view. Today’s liabilities are measured against today’s assets, or today’s earnings are compared against today’s interest payments.
As a long-term investor I’m primarily interested in where the company and its share price will be in the future, by which I mean 5 year from now at the very least. In that context it makes little sense to compare current interest payments to current earnings. What about next year’s earnings, or the year after?
The real question that I want to answer is:
Can the company comfortably carry its debt burden over my potential holding period of 5 to 10 years?
To answer this I decided to take a different approach and compare the company’s debts against a conservative, ballpark estimate of what it may be able to earn over the next decade. I call this ballpark estimate of future earnings the company’s future earnings power.
The calculation is simple. I take the average earnings per share over the last decade and multiply it by 2 to get a conservative upper limit for the next decade’s earnings (doubling earnings implies a 7% annual growth rate, which is higher than most companies can manage).
I then multiply that number by the company’s growth quality (I covered the calculation of growth quality in How to find reliable, profitable dividend growth, and you can apply it to any company you like with this investment worksheet and spreadsheet).
So if a company’s growth quality is 100% then I am effectively assuming it can grow at 7% a year (which is conservative for the very few companies that can grow with 100% consistency), and if it’s growth quality is 50% (which is an indicator of little or no growth) then I’m assuming that the next decade’s earnings will be no better than the last (which again is conservative as no growth actually means the company is shrinking in inflation adjusted terms).
I then compare the company’s total borrowings to its future earnings power. Total borrowings can be found on the balance sheet, or quickly estimated as net debt plus cash in the bank.
I call the ratio between total borrowings and future earnings power the company’s “debt ratio”, and my current upper limit for this ratio is 5. So if a company has borrowed 5 times more than my estimate of its average earnings over the next decade, I won’t invest.
Why 5? Because it seems to give a reasonable balance between avoiding companies with high levels of debt and allowing successful companies to carry enough debt to make them operationally efficient.
So far this approach has kept me out of trouble; for example, it highlighted potential problems at FirstGroup. FirstGroup’s debt ratio was well above 5 before the company announced a major rights issue which ultimately had a significant negative impact on the value of its existing shares.
However, it is entirely possible that a company with a high debt ratio could carry that debt for many years, or even decades, and profit handsomely from the additional leverage. On average though, I think those few companies which break the limit are best avoided.
There will always be other companies with rapid and consistent growth that do not use large amounts of debt to boost their returns, and those are the companies I prefer to stick with.
Pension fund liabilities
Another financial obligation I look at is pension liabilities, which arise from having a company-backed defined benefit pension scheme.
With these schemes the final pension is pre-defined and is a legal obligation. If the pension fund’s assets grow too slowly to be able to cover future obligations then there will be a pension fund deficit, and the company may have to feed cash into the pension fund to close the gap between assets and liabilities.
Cash which may have to be diverted into the pension fund is cash that cannot be invested productively in the business or paid out to shareholders. This puts the risk of poor pension investment performance onto shareholders rather than employees.
In most cases these funds (which are now almost all closed to new employees) are relatively small and manageable, but in some cases they are huge and represent a significant risk to future cash flows.
Most investors I know either don’t look at pension liabilities or, if they do, they only look to see if the fund has a deficit, i.e. if its assets are less than its liabilities.
The problem with just looking at the size of the pension deficit is that it may be small or non-existent today, but what about next year, or five years from now?
If a company is earning £100m each year and the pension deficit is £10m then that doesn’t seem to be a big problem; the deficit can be closed with just 10% of one year’s earnings. But this approach fails to answer the real question:
How big could the deficit be several years from now?
If, in the previous example with the £10m deficit, the liabilities are £100 million and the assets are £90 million then there is little to worry about. No matter how badly the invested assets perform the maximum deficit is £100 million (in the very unlikely case that all the assets are lost).
However, what if the liabilities are £2,000 million and the assets are £1,990 million? In that case the deficit could easily widen out to £100 million, or even £500 million. That would represent a significant drag on future cash as a large amount of cash would have to be fed into the pension fund’s assets to close the funding gap.
So for me, the pension liabilities are far more important than whether or not there is currently a surplus or deficit. The next question is:
How big a pension is too big?
Again there is no magic number, but currently I use a cut-off point of 10 times the company’s estimated future earnings power.
This is high enough so that the vast majority of companies are considered prudent, but where a deficit of say 10% represents a meaningful risk to future cash flows. It also produces an upper limit which is similar to the company’s market cap, which is a more mainstream number to compare a company’s pension liabilities to.
Defensive value investing is low debt investing
Whether you use my metrics to rule out highly indebted companies or if you choose more conventional ones, the important point is to rule them out one way or other.
When a company has debt related problems they can quickly escalate into suspended dividends, dilutive rights issues and bankruptcy, none of which is particularly compatible with the kind of low stress environment in which a defensive value investor should try to operate.