Debt to Capital at Book

Debt to Capital at Book measures the risk of the firm's capital structure in terms of amounts of capital contributed by creditors and that contributed by owners. It expresses the protection provided by owners for the creditors. In addition, low Debt/Equity ratio implies ability to borrow. While using debt implies risk (required interest payments must be paid), it also introduces the potential for increased benefits to the firm's owners. When debt is used successfully (operating earnings exceeding interest charges) the returns to shareholders are magnified through financial leverage. Depending on the industry, different ratios are acceptable. The company should be compared to the industry, but, generally, a 3:1 ratio is a general benchmark. Should a company have debt-to-equity ratio that exceeds this number; it will be a major impediment to obtaining additional financing. If the ratio is suspect and you find the company's working capital, and current / quick ratios drastically low, this is a sign of serious financial weakness. Risky businessOn top of the risk associated with potential valuation disparity, investing in low-P/B companies exposes investors to greater market risk. In his book Investment Fables, Aswath Damodaran compares low-P/B stocks (defined as stocks with a P/B of less than 0.8) with the rest of the market on three different measures of risk: standard deviation, beta, and debt-to-capital ratio, where capital is defined as the book value of equity plus debt. His analysis showed that as a group, low-P/B stocks exhibit a lower beta (implying less risk) than the rest of the market, but have a higher standard deviation and debt-to-capital ratio. Standard deviation is a measure of how much a stock fluctuates over time. From a statistical standpoint, it's measured as the square root of a security's volatility. Beta takes this one step further, comparing the volatility of the underlying security with that of the overall market. In essence, it's measuring how changes in the market will affect a stock's price -- the higher the beta, the greater the effect. Investors who hold stocks with higher standard deviations and betas have a greater chance of being "in the red" at some point in time on their investment, which is why some people use these metrics to quantify market risk. For those who aren't overly concerned about the daily fluctuations of their investments, the higher debt-to-capital ratio of low-P/B stocks is the most disconcerting risk. A high debt-to-capital ratio indicates that a company cannot generate adequate returns on its assets, relying heavily on debt instead. There's nothing wrong with companies taking on debt to reduce theircost of capital. However, the more debt a company takes on, the more leveraged it becomes, adding to its risk of default. Whatever your definition of risk may be, when selecting investments from a pool of low-P/B stocks, it's important to determine whether the potential for excess returns outweighs the additional risk. It's easy to see why many investors are drawn to stocks that trade below their book value. Still, it's important, as always, to not get tied up in a single metric. Although these types of investments have generated excess returns in the past, it would be small-f foolish for someone to blindly choose a portfolio of low-P/B stocks without first considering the potential valuation disparity caused by accounting procedures, and the additional risk associated with such investments.