Governments may rectify economic problems by issuing bonds or printing money, whereas companies gain financial leverage mainly through corporate bonds. Increasing debt is one strategy, but it is a careful balance, because a company with high debt may be swinging above its weight class.
Banking companies borrow money and then lend it out at a higher interest rate. Utilities are also heavy borrowers to pay for infrastructure costs. In an increasing interest rate environment, however, it is important to have a watchful eye on over loaded debt.
A key measure is the debt-to-equity ratio (D/E), which, according to Investopedia, “is a debt ratio used to measure a company’s financial leverage, calculated by dividing a company’s total liabilities by its stockholders’ equity. The D/E ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity.”
There are two ways to drive this ratio down: pay down debts or drive up the value of the company. The D/E is a way to screen for financial leverage.
It may come as a surprise, but, year over year, among 258 TSX companies, 68 stocks with D/E above one actually outperformed 190 stocks with D/E less than one. That’s right. Heavier-in-debt stocks are up 17% for the year. Lighter-debt stocks rose 6.7%, which is underperforming the TSX market as a whole by 230 basis points.
|Greater than 1||Less than 1|
|Number of TSX companies||68||190|
|52-weeks average performance (%)||+17%||+6.7%|
Information accessed from TD waterhouse
Could this trend continue? Maybe, but it’s not likely and certainly not across the board.
Heavier debt didn’t slow these stocks down
Tucows Inc. (TSX:TC)(NASDAQ:TCX) is a diversified internet service company that has been a heavy-hitting stock and can handle the high leverage with a D/E of 1.7. This stock up 75% for the year; it tends to double (yes, double) in value each year.
Getting even lighter on debt
The D/E peaked for Saputo Inc. (TSX:SAP) at 0.6 in recent years, but it has now been chopped in half. The earnings per share (EPS), now at $1.91 per share, have more than doubled over the last 10 years. This is a nice combination for a company that has steady revenue from solid footing in the global cheese market.
Moving from heavier to lighter debt
Canadian Pacific Railway Limited (TSX:CP)(NYSE:CP) has clawed back on D/E, while the EPS continue to climb. Dropping D/E below one would be a strategy to keep financial leverage to within historic levels, which would make this transportation stock even more attractive.
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Fool contributor Brad Macintosh has no position in any stocks mentioned. Tom Gardner owns shares of Tucows. The Motley Fool owns shares of Tucows. Tucows is a recommendation of Stock Advisor Canada.