As Mary Buffett & David Clark, authors of Buffettology have accurately pointed out,
“Warren has found that a company with [a] durable competitive advantage spins off a lot of cash and has little or no need for debt.”In other words, a good indicator of an economic moat is a balance sheet relatively free of long-term debt.
But before investors analyze a balance sheet, it’s important for them to differentiate between a cigar-butt value investment in which investors are aiming to purchase liquid-able assets at a discount, or an investment in a business for its growth or dividend.
An investment in Apple, for example, would not be based solely on its liquid-able assets.
For instance, at 3.4 times book value, Apple would not be able to return $450 per share to investors if the company halted operations and sold off its assets.
Gravity (GRVY), on the other hand, would likely serve investors well in the case of a liquidation; at today’s price, the stock trades at just .4 times book value.
Though seasoned investors grasp this concept with ease, the beginner investor might have trouble understanding that each stock’s balance sheet deserves a somewhat unique and line-by-line analysis.
There is a Problem with the Debt to Equity RatioAs far as analyzing a company’s debt situation, in particular, investors should be careful not to jump right to the debt-to-equity ratio. There is a huge problem with the debt-to-equity ratio when it comes to assessing companies as ongoing concerns: It takes free cash flow to meet debt obligations, not equity.
So what is an alternative to the frequently used debt-to-equity ratio? The long-term debt burden ratio.
An Alternative to the Debt-to-Equity RatioThe commonly used debt-to-equity ratio is, unfortunately, not always a useful measure of financial health, especially when examining wide-moat stocks.
The debt-to-equity ratio measures debt relative to assets. But since the wide-moat stock probably won’t be liquidating assets any time soon (if it is liquidating, it’s probably not a wide-moat stock), it is better to focus on a firm’s ability to service its debt.
As Mary Buffett and David Clark emphasize, “the ability of a company to use its cash flow to service and pay off the loan is far more important than the assets backing it up” (click to tweet this quote).
So, to assess financial health, I divide long-term debt by TTM free cash flow (FCF) (or owner earnings) to find out how many years it would take the company to pay off its long-term debt with its current cash flows.
This ratio is referred to as the long-term debt burden.
A rule of thumb is that companies with durable competitive advantages can typically pay off their long-term debt with three years of TTM FCF or less. Hence, wide-moat companies should have a long-term debt burden ratio of three or less.
Since smaller companies have very volatile FCF and owner earnings, it’s important to take a look at this trend closely and use an initial number that makes sense. After evaluating the company’s competitive landscape, some sort of average is often sufficient, unless the landscape has changed dramatically in the recent past.
Take your time on this part. As the saying goes: garbage in, garbage out.
An Example of the Long-Term Debt Ratio In UseHere is an example of five companies that have either a narrow or wide moat designation by Morningstar.
True to their moats, all of the companies have a long-term debt burden of less than three years.
The ratio typically uses earnings, but I feel that free cash flow or owner earnings paints a clearer picture. Free cash flow is ultimately what is used for long-term debt repayment after short-term commitments have been met.
When to DeviateYes, Buffett sometimes breaks this rule of thumb of “three or less.” Railroads, for example, typically carry very high levels of long-term debt. Berkshire’s largest acquisition to date, of course, was Burlington Northern Santa Fe Railroad.
A deviance from this rule of thumb should be based on at least one of two reasons:
- The stock is significantly undervalued with more than enough margin of safety.
- The company has obvious and significant barriers to entry (e.g. railroads).