Investor Education: Debt-To-Equity Ratio
Solvency measures the ability of a company to pay off its debts. The debt-to-equity ratio (D/E) is a solvency ratio that takes a company's total liabilities and divides them by its shareholder equity. D/E is an important metric when analyzing a company, as it measures a company's financing through debt versus other funds from shareholders. This metric is imperative to use in times of uncertainty. If a company has a high D/E ratio in times of economic uncertainty, it could worry shareholders as the company may not be able to fulfill its debt obligations.
Read our overview of Debt-To-Equity Ratio
Jamie White presented Global Blood Therapeutics on September 15th, 2021 on Lunch at the Club. The closing price the day of the presentation was $25.97. GBT has seen a significant price increase on Pfizer M&A rumors.
Global Blood Therapeutics Stock Soars Following Pfizer M&A Rumors (Updated)
Inflation and Earning Power
“The correct answer to the question, ‘What does inflation mean to common stocks?’ is: ‘Whatever inflation means to their earnings and dividends.’” —Thomas Phelps (“100 to 1 in the Stock Market”)
Inflation is a cruel tax. And in the business world, that tax hurts some businesses more than others.
Few businesses are helped by inflation. Some can be significantly hurt by inflation—such as those with high, variable debt obligations that also have high capital expenditure requirements. And almost all businesses will be hurt by inflation if it gets so high that the economy has trouble functioning under its weight.
Most businesses can deal with it over time. Costs rise, so they raise prices. Some companies can raise faster than others, but overall, if they are making something or providing a service that people want, customers will eventually pay those higher prices.
With those higher prices comes higher earnings. But during inflationary times, increased earnings can be a misleading metric for judging business quality and growth prospects—and thus the investment merits of that business.
The effect on earnings during inflationary times is a topic Warren Buffett has touched upon over the years. For example, during a previous bout of inflation, a 1981 article in The New York Times discussed some comments made by Buffett:
In Mr. Buffett's view, it is a mistake to focus on reported earnings in determining how the owners of a business did. Only gains in purchasing power represent real earnings on investment, he says, and he uses this illustration to prove his point:
“If you (a) forgo 10 hamburgers to purchase an investment, (b) receive dividends which, after tax, buy two hamburgers and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won't eat richer.”
In effect, he says, inflation creates a tax on capital and the current double-digit rate of inflation makes most corporate investment unwise, at least if measured by the criterion of a positive actual investment return to the owners of the business.
What an investor should focus on is not earnings but earning power. Is the company improving its competitive position? Is it investing capital at returns well above the rate of inflation? As described in the book 100 to 1 in the Stock Market:
Stocks go up and down for many reasons having nothing to do with changes in their earning power. Even their earnings may go up or down for many reasons having nothing to do with their earning power. Anyone hoping to make 100 for one in the stock market by way of earnings growth must focus on earning power.
What is the difference between earnings and earning power?
Earnings are simply reported profits no matter how obtained. As we have already seen, earnings may rise because of a sudden, non-recurring surge in demand, because of a price advance, because of a change in accounting practices, because of improvement in business generally which permits utilization of what previously was excess productive capacity. None of those reasons reflects earning power any more than the movement of a cork downstream attests its motive power.
Earning power is competitive strength. It is reflected in above-average rates of return on invested capital, above-average profit margins on sales, above-average rates of sales growth. It shows to best advantage in new or expanding markets.
Failure to distinguish between ephemeral earnings fluctuations and basic changes in earning power accounts for much over trading, many lost opportunities to make 100 for one in the stock market.
Whether the current inflation persists for months or years or decades, understanding how the businesses in your portfolio are positioned for it can go a long way in helping you cut through the noise and earn returns that outpace whatever inflation rate the future has in store for investors to navigate.
“The best way out is always through.” —Robert Frost
Tweet of the Week
In Case You Missed it…
Dare To Be Naïve - by Chris Mayer
Reality Catches Up - by Morgan Housel
Concentrated Portfolio: Challenging the Market [with Tom Russo]
Value Hive Podcast: Paul Andreola: How To Find The Next XPEL [Related paper: XPEL Case Study]
Watch List and Earnings Under $250M
Since we began tracking Open Market Buys, $KFS has seen 34 purchases from insiders for just under $3 million. The stock has performed pretty well since the close of May 20 (the Friday before we started tracking).
If you were to have bought the stock at that closing price, you would have seen appreciation of 34% over that timeframe.
The Co/Investor Club has a watch list for premium members. These companies have been profiled by investors we follow, The Co/Investor Club team internally, or by our premium members. We may or may not own the names on our watch list. We heavily encourage all members to do their own due diligence as this is not investment advice. If you would like to discuss any of the names or share a name you believe needs more attention, please feel free to reach out to sam@avenelfinancial.com.
We understand how much our premium members enjoy staying up-to-date on the small and microcap markets. Given that most investors know when the companies in their portfolio and larger companies are reporting earnings, we have decided to keep our members up-to-date on companies reporting earnings that have a market cap of under $250 million. You can log into the premium member portal each week to see which companies that have a market cap of $250 million and under are reporting in the upcoming week.
To have access both of these, please sign up for the Co/Investor Club Premium Membership.
If you have not already upgraded your membership…
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