This is a recent AI-generated response to an inquiry regarding high company debt ratios:

As indicated in this passage, a high total-debt-to-total-asset (TD/TA) ratio is often thought to signal a greater chance the company will default, marking the stock as being high risk. But is this always the case? And does it mean stocks with a high debt ratio should be avoided?

To answer these questions, it’s important to consider the company’s industry. TD/TA ratios vary widely across sectors, with financial firms generally carrying the highest ratios and health care the lowest, as shown in Table 1. An 80% debt ratio, as mentioned above, is equal to or higher than the average in each of the 11 sectors, signaling increased risk in each sector according to conventional standards.

Source: AthenaInvest. October 2024 sample of 3,120 stocks traded on U.S. exchanges.

Most investors, including professionals, are looking for high-quality balance sheets. A debt ratio above the industry average will very likely discourage them from considering the stock as it is one of the metrics by which quality is measured. So, a stock with a debt ratio higher than 80% may have relatively fewer takers regardless of the industry in which it operates.

Debt ratios and undervaluation

Does this lower demand present a buying opportunity? It turns out that higher debt ratios correlate with stock undervaluation, as measured by price-to-sales (P/S) ratios (see Table 2). A quarter of measured stocks, with debt ratios exceeding 80%, have the lowest P/S ratios.

Source: AthenaInvest. October 2024 sample of 3,120 stocks traded on U.S. exchanges.

If high debt ratios universally signaled greater risk, these stocks could be unattractive. But their low valuation ratios might indicate a buying opportunity instead. Empirical evidence from several academic studies shows that companies with higher debt ratios can generate higher returns for their company’s stock. Many of us have experienced such benefits when purchasing a house using debt ratios that can exceed 80%, generating returns many times the rate of appreciation for the underlying house.

Is there a way to make these generally undervalued but theoretically less popular stocks more appealing?

Creditors as risk managers

A lender’s perspective is quite different from conventional wisdom. Creditors, who stand to lose their principal and interest, perform rigorous risk assessments before lending. Thus, a high debt ratio signals creditor confidence in the company’s ability to manage its debt obligations rather than indicating a higher risk of default. Creditor’s lending is a highly credible “put your money where their mouth is” economic signal as they could lose everything if they are wrong.

For potential equity investors, creditor behavior can offer an important alternative to the conventional wisdom surrounding debt ratios. Rather than indicating higher default risk, a high debt ratio may suggest lower default risk based on the creditor’s decision to lend.

Dividend suspension as an early warning

Creditors and their analysts are brutally honest regarding a company’s default risk, but over time the company’s financial health can change from when the lending decision was first made. Dividend-paying companies can provide additional protection against a default.

By deciding to pay dividends, company management signals confidence in the stability of cash flows. Dividends act as another “put your money where your mouth is” measure of cash-flow confidence. While initiating dividends often raises stock prices, suspending them often leads to a large price drop. For a dividend-paying company with a high debt ratio, this combination indicates there is confidence that cash flows are sufficient to cover dividends as well as debt obligations.

Debt covenants require companies to reduce or suspend dividends if cash flows fall short, providing investors with an early warning of financial trouble. Non-dividend-paying companies lack this safety valve, making less reliable the link between debt ratios and default risk.

Turning conventional wisdom on its head

Debt is a highly emotional concept. We see this in news reports that use debt as a way to attract readership, from the national debt to personal debt to the trade deficit to the foreign ownership of U.S. debt. It is not that these stories are unimportant, but they punch well above their weight for attracting eyeballs.

This is also the case with company debt. The mention of a high debt ratio can be a deal killer for many investors. This, of course, presents a buying opportunity if investors collectively respond irrationally to this measure.

On the contrary, a high debt ratio can be an indication that creditors believe the company’s default risk is low since they have made the hard-nosed decision to provide funds to the company that could be lost if the company does default. If the company also pays a dividend, there is an early warning of default since the creditors will require the company to reduce or suspend the dividend if it is believed cash flows are insufficient to meet interest and principal payments.

Thinking of high debt ratios in this contrary way turns conventional wisdom on its head. High debt ratios can signal lower potential default risk and a potential buying opportunity.

Lambert Bunker, vice president at AthenaInvest, contributed to this commentary.

The opinions expressed in this article are those of the author and the sources cited and do not necessarily represent the views of Proactive Advisor Magazine. This material is presented for educational purposes only.