The Debt-to-Equity Ratio in Valuation and Financial Modeling: Quick Risk Assessment?

Debt-to-Equity Ratio Definition: The Debt-to-Equity Ratio equals a company’s Total Debt / Total Common Shareholders’ Equity and, depending on the context, may be based on either the book values or the market values of these items; it measures the company’s overall risk from leverage and can indicate how expensive its next Debt issuance might be.

Many sources online present the “textbook” definition of the Debt-to-Equity Ratio:

While this version is useful for financial statement analysis, it’s too limited because this ratio might also be based on the market values of Debt and Equity, i.e., how much other investors might be willing to pay for them.

The market value version is more common in valuation and DCF analysis for calculating the Discount Rate, or WACC:

In both cases, the Debt-to-Equity Ratio indicates a company’s risk from leverage, i.e., the extra risk it assumes by using Debt to fund its operations.

If a company uses too much Debt, it risks defaulting on its interest payments and principal repayments.

But even without a default, there is still additional risk because this Debt Service might “crowd out” the company’s funds available for growth and maintenance and limit the company’s potential.

In extreme cases, companies with high Debt-to-Equity Ratios could even be at heightened risk for bankruptcy.

Files & Resources:

• Debt-to-Equity Ratio Analysis for Builders FirstSource (Historical Statements and Simple DCF) (XL)
• Debt-to-Equity Ratio Impact on Implied Enterprise Value in a DCF (XL)
• Debt-to-Equity Ratio – Slides (PDF)
• Builders FirstSource – 10-K (PDF)
• Builders FirstSource – 10-Q (PDF)

Video Table of Contents:

• 0:00: Introduction
• 2:59: Part 1: Basic Calculations
• 4:57: Part 2: What is a “Good” Debt-to-Equity Ratio?
• 6:30: Part 3: Debt to Equity in Valuation
• 10:38: Part 4: Debt to Equity in Credit Analysis
• 13:22: Recap and Summary

How to Calculate the Debt-to-Equity Ratio

To calculate the Debt-to-Equity Ratio in the context of a 3-statement model or credit analysis, simply take the company’s Debt and divide it by its Common Shareholders’ Equity.

You do not use its Total Equity, as this number might also include Preferred Stock and Noncontrolling Interests, which are separate items (see our Statement of Owners’ Equity tutorial for more).

Here’s an example for Builders FirstSource in the building materials industry:

Some sources suggest that this ratio should be based on Total Liabilities / Common Shareholders’ Equity, but that is not the traditional definition because “Total Liabilities” includes much more than just Debt!

Including Liabilities such as Accounts Payable and Accrued Expenses in this number is silly because they are short-term items that do not bear interest.

Therefore, they do not impose the same default or bankruptcy risk as Debt; unless something highly unusual happens, companies cycle through these items regularly.

You could potentially include other interest-bearing Liability and Equity line items in the “Debt” balance here, such as Preferred Stock or Finance Lease Liabilities, but it becomes a different metric with that approach.

In a valuation context, you normally use the Debt-to-Equity Ratio based on the market values to un-lever and re-lever Beta in the WACC calculation:

Unlevered Beta = Levered Beta / (1 + Debt / Equity * (1 – Tax Rate) + Preferred / Equity)

Re-Levered Beta = Unlevered Beta * (1 + Debt / Equity * (1 – Tax Rate) + Preferred / Equity)

As the subject company’s Debt-to-Equity Ratio increases, its Re-Levered Beta increases, so its Cost of Equity goes up.

Its Cost of Debt also starts to increase.

Initially, if the company is at a moderate Debt level, its WACC might fall because Debt is still cheaper than Equity.

But above a certain Debt level, WACC starts to rise, reflecting the added risk from leverage.

Interpretation: What is a “Good” Debt-to-Equity Ratio?

While it’s tempting to say that “lower is better” and “higher is worse” with this ratio, that’s not quite how it works.

Generally, it’s best if a company’s Debt-to-Equity Ratio is close to the levels of its peer companies (i.e., the set used in a comparable company analysis).

For example, you can see the range of values for the Builders FirstSource [BLDR] peer companies below:

These calculations are based on the market values of Debt and Equity for each company, and they tell us that BLDR’s leverage is close to the median of the set.

If BLDR had a much lower Debt-to-Equity Ratio, such as 5%, that wouldn’t necessarily be positive.

Since Debt is cheaper than Equity, it generally benefits companies to use Debt up to a reasonable level because it provides cheaper financing for their operations.

So, with a Debt-to-Equity Ratio this low, BLDR might be poorly optimized.

If the Debt-to-Equity Ratio is too high, such as 60% here, that is a negative sign because it means the company is assuming far too much credit risk.

A company with a ratio this high will almost certainly have to pay a premium to issue Debt in the future based on the YTM of bond issuances.

If you calculate this ratio based on the book values of these items, you can expect to get much higher percentages because the book value of Equity is almost always much lower than a company’s Equity Value or Market Cap.

Once again, though, comparability is king.

If you calculate the ratio this way, also do so this way for the peer companies and make the comparison based on the book values:

How Does the Debt-to-Equity Ratio Affect Credit Analysis?

In credit analysis, the Debt-to-Equity Ratio is just one factor influencing a company’s profile and potential credit rating.

Lenders also look at metrics like the Leverage Ratio (Debt / EBITDA), Interest Coverage Ratio (EBITDA / Interest), Liquidity Ratio, and many others to judge a company.

Balance Sheet-based metrics like the Debt-to-Equity Ratio are less important than metrics involving the Income Statement and Cash Flow Statement because lenders care mostly about a company’s ability to service its Debt.

In other words, if a company’s Debt / Equity is on the high side, that doesn’t necessarily matter if the company still has a reasonable Debt / EBITDA and EBITDA / Interest.

Debt / Equity may play more of a role in financial statement analysis because an above-normal number could inflate a company’s Return on Equity (ROE) and other Returns-based metrics.

Here’s an example of what might happen when a company’s Debt-to-Equity Ratio increases:

Note that, as stated in the image, this scenario is a bit unrealistic because the company’s Interest Rate on Debt would almost certainly change if it went from 20% to 50% Debt / Total Capital.

So, the ROE could still increase, but would probably not to the extent shown here.

How Does the Debt-to-Equity Ratio Affect Valuation?

In a DCF analysis based on Unlevered FCF, the company’s capital structure still factors in because it affects the Discount Rate.

You can see a simple example of how higher Debt levels affect WACC below (from the sample Excel file here):

As the Debt-to-Equity Ratio increases, the company’s Cost of Equity and Cost of Debt both increase, and past a certain level, WACC also starts to increase.

Therefore, the company’s implied value from the DCF increases up to a certain Debt-to-Equity Ratio but then decreases above that level.