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Author: StevnFool Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 211905  
Subject: Re: Old favourites. Date: 5/3/2012 5:48 PM
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Kellogg: Total Debt to equity 283%
Campbell Soup DtoE 240%
Heinz d to E 176%

Some of WEB`s old favs, no holdings now I think, perhaps because of the levels of debt.

Why have these quality companies levered up so much - poor management , expansion trail?

They look attractive on paper but the debt puts me off.


This is probably just evidence that Debt to Equity is a poor ratio to use when evaluating a company. What this probably says is that the book value of equity vastly understates the real value of that equity. Take Kellogg for instance. Price to book = 8.75. The market perceives that this company is worth much more that the value of the equity shown on its books. Let's assume for a moment that the value of equity on its books were 5 times what it actually is, the ratios would become:

Price to book = 1.75
Debt to Equity = 48%

You probably wouldn't bat an eyelid at those numbers.

You need to remember that for a variety of reasons, the book value of equity can drift a long, long way from the real value of equity. A good example is share buy backs above book value per share but below the intrinsic value per share. This results in an increase in value per share but a reduction in book value (of equity) per share.

Jim (mungofitch) has pointed out that a much better measure to assess the debt of a company is to compare it to earnings rather than to equity. For a typical company if it is less than 5 years of trend or sustainable earnings, you would consider the balance sheet pretty solid. In other words, the company could theoretically buy back all its debt in 5 years.

For Kellogg, depending what you include in debt, it is in the range of $5B to $7B (I usually use a conservative Total Liabilities - Current Assets). From the income statement at Yahoo, the "Net Income Applicable to Common Shares" is ove $1.2B in each of the last 3 years. This would comfortably support debt of $6B.

I would consider this an acceptable level of debt.

I didn't look at the other companies but I suspect a similar story.

Thinking of Kellogg another way. Consider you were in a startup situation, how much equity would you be prepared to put into it (assuming you had it) if you were fairly confident that it would generate earnings each year of $1.2B. I suspect you would be prepare to invest about $15B of equity. For a new company, the book value of equity would exactly equal the $15B you put in. If your new company also had $5B to $7B debt, I don't think you would be worried too much.

Sometimes you need to look at things from different perspectives.

StevnFool
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