The total debt to equity ratio is a measure of a company’s financial leverage. A high debt to equity ratio can indicate higher financial risk due to potentially higher interest costs associated with the debt and the future need to either pay back the debt or roll the debt forward with new financing. Alternatively, if returns on the debt are higher than the debt costs (interest) the increased leverage can boost overall returns on equity. The total debt to equity ratio is calculated as follows:
Total Debt to Equity Ratio = Total debt / Shareholders equity
Let’s take a look at a backtest of this ratio to see how it works. I used the data and backtesting tool provided by Portfolio123. This backtest uses the same filtered universe of stocks as my recent Current Ratio Backtest. I’ve designed the filtering criteria for this backtest specifically for individual investors and with a focus on enhancing data quality. The filters include the following criteria:
- No OTC stocks. Stocks not traded on the New York Stock Exchange, NASDAQ, or American Stock Exchange markets are excluded. The quality of fundamental stock data for OTC can be somewhat lower and less timely that that for stocks traded on major exchanges.
- No ADRs. Fundamental data for foreign American Depositary Receipt can include errors due to currency exchange, different accounting standards, and share count.
- Liquidity test. The average daily total amount traded over the past 60 trading days must be larger than $100,000. This amount was selected so that a $1 million dollar portfolio could hold 100 positions and that each new $10,000 position would not exceed 10 percent of a day’s trading volume. The liquidity test also ensures that the backtest has reliable market price information for any of the stocks that are being tested.
- Market Cap > $50 million. Nano cap stocks are excluded to help improve data quality. This filter also ensures that positions in a modest sized portfolio never exceed one percent of shares outstanding or the available float for a company.
- Price > $1. True penny stocks are excluded due to various information issues and manipulation of these stocks.
- Total Debt to Total Equity Ratio not missing. This filter insures we are looking at stocks that actually have data on the total debt to equity ratio.
After these filters are applied, we are left with approximately 3,200 to 4,100 stocks. These stocks are then ranked by the criteria being tested; in this case, we are testing the total debt to equity ratio. The lowest 20 percent of stocks ranked by the total debt to equity ratio are placed in the first quintile and the next 20 percent in the second quintile and so forth until we have five portfolios of stocks. The portfolios are rebalanced every 12-months and compounded annually to more realistically replicate what an individual investor might be expected to do to avoid higher short-term capital gains tax and trading costs. The following 5 charts display the quintile returns for the current ratio in red and the S&P 500 Equal Weight Index in blue. The first quintile includes the companies that had the lowest total debt to equity ratios and the 5th quintile includes the companies that had the highest total debt to equity ratios.
Total Debt to Equity Ratio Quintile Returns – 2000 – 2013
Summary of Results for the Total Debt to Equity Backtest
This backtest of the total debt to equity ratio reveals that the third, fourth and fifth quintiles (the quintiles with the highest debt to equity ratios) outperform the S&P 500 Equal Weight Index benchmark. These results might be surprising to some investors that tend to favor stocks with lower debt to equity ratios. However, it appears the leverage associated with increased debt often does result in increased stock returns.
What did surprise we was the under-performance of stocks in the 1st quintile, which typically have zero debt. Give recent low interest rates, it could be that debt free companies are hurting their returns by not taking on some leverage.
Overall, I would not recommend using the total debt to equity ratio by itself to chase stock returns. While high levels of debt may result in increased stock returns for some companies, it can also lead to blowups during credit tightening periods or economic slow downs if interest payments cannot be maintained. While there might be higher returns associated with higher levels of debt, the increased risk of a permanent loss of capital when dealing with companies that carry excessive debt may exceed the benefit of those returns. This ratio is best paired with other fundamental stocks ratios.