Investors in stocks should understand the role that debt plays in enterprise valuation. Did you know that stock price is only one part of a company’s value? The other component is debt, and it’s awfully important for investors to grasp its significance.
Think of debt (bonds, bank loans, etc.) like the portion of an iceberg that lies beneath the water’s surface. The part of the iceberg that rises above the surface is stock price. Visible to everyone, stock price gets all the attention, yet it often represents only a small portion of the company’s total capital.
Here’s how it works. The basic balance sheet equation from Accounting 101 is Assets = Liabilities + Owner’s Equity. What this formula says is that the assets of a corporation are funded by one of two sources: liabilities (think debt) and equity (think stock).
Oh, and one more thing: the debtholder’s claim on corporate assets is superior to the stockholder’s claim. The stock price, therefore, is a residual value – what’s left over after all debts have been deducted. If for any reason the market thinks a company has insufficient resources to pay its debts when due, the stock price is likely to plummet. Unfortunately, I’ve learned this from experience.
So, the next time you find a so-called “cheap” stock, be sure to check out its balance sheet. If it’s loaded with debt, then it may not be as cheap as it looks!