The situation with RadioShack is the perfect lesson about debt to equity ratio. I think they will be bankrupt soon. Don’t take my word for it though, here’s why I think RadioShack is the perfect debt to equity ratio example of how not to run a company.
The debt to equity ratio is a quite simple formula. It’s a great indicator for how risky a stock is, and I’ve written in length about this subject. For those of you who are unaware, here’s the formula:
Debt to Equity = Total Liabilities / Shareholder’s Equity
In the above equation, shareholder’s equity is also calculated in a very simple way. You can look it up in the official annual report, or you can just take a company’s total assets and subtract their liabilities. It’s just a measure of how much assets a company has compared to their liabilities.
As a shareholder, you most certainly want to see equity. You can even argue that a company without equity is useless. I mean, sure it might produce profits, but obviously they haven’t made much progress yet towards building a solid financial foundation. If you want to speculate on these kind of companies be my guest, but I’d prefer to invest in the stock with a fortress of a balance sheet.
Debt to Equity Ratio Example: RSH
All of this explanation leads us to today’s troubled stock: RadioShack (RSH). I’ll show you exactly how dire their situation is right now, and it’s a big part due to their debt to equity.
As you’ll soon see, this company’s equity has quickly eroded at a sickening and destructive pace. This destruction of equity in turn causes their debt to equity ratio to skyrocket, but it doesn’t stop there.
Now a smart alec might say that RadioShack is in a dying industry, so it must obviously go bankrupt. This statement is absolutely true, but a dying industry doesn’t determine a company bankruptcy. Just look at Barnes and Noble (BKS). They are in the fast falling industry, book sales, yet they are still alive and well. At the same time, their competitors Borders went belly up. It’s all due to balance sheets and how managements are handling the finances.
Let’s dig into this debt to equity ratio example. Here’s a snapshot from the company’s latest 10-k (annual report):
First thing that screams out to me.. look at their change in shareholder’s equity! They went from $598.7 million in 2012 to $206.4 million in 2013. That’s more than half of a drop!
Surely the company’s value quickly became half as much. Sure enough, the market agreed. They went from almost $10 a share in the beginning of 2012 to the $2 – $3 range in 2013. Wouldn’t want to be left holding that bag.
Now let’s calculate the debt to equity. Remember,
Debt to Equity = [Total Liabilities] / [Shareholder’s Equity]
Debt to Equity RSH = [$1,384.8] / [$206.4]
Debt to Equity RSH = 6.7
To the novice investor, this might not seem like that high of a debt to equity ratio. But I always preach that you want at least a debt to equity below 0.5. Why? This means your assets cover your liabilities by at least 2-to-1, and s0 you’d be safe if there was a market crisis.
This debt to equity ratio example of RadioShack during 2013 is extremely high. Especially if you consider that their debt to equity in 2012 was only 2.8, and in just one year’s time it’s jumped to 6.7.
RSH became over twice as leveraged in just one year! Notice how this is very similar to their loss of more than half their equity! If these aren’t signs of a deteriorating business I don’t know what is.
As an investor you should never have to subject yourself to such abuse. The chances of a recovery with this kind of erosion are slim. And at this point you aren’t investing. You are playing Russian Roulette with your dollars.
So what would I have done in this situation? Let me be completely transparent. I have very strict and set rules about my investing philosophy. You’ve read about them thoroughly, especially if you are a fan of the blog and have read my ebook. Even in there I have my strict rules for investing.
What Would I Do?
Would I have taken damage from RadioShack (RSH)? Short answer is, no. Even if I did see value in the company back then, my rules would’ve had me out of the stock by August 2012. This is when they stopped paying a dividend. Even this was too late.
I assure you I would have been out even before that. I always implement a 25% trailing stop with all of my positions. To guard from a situation exactly like this. So even if I saw value in 2010, 2011, or even 2012, I would’ve been out at most with a 25% loss.
Compare that to someone who might’ve bought around $20 and has held on, waiting for the price to return to its supposed value. The stock is now around $1! A loss of 95%!!!
Again, compare the difference between a 95% loss and a 25% loss. A 95% loss would turn $10,000 into $500, while a 25% loss would turn $10,000 into $7,500. Do you know how long it’d take to earn back that extra $7,000 loss? With only $500, you’d have to find a 15 bagger! Good luck!!
Value Trap Indicator for RSH
I’m rounding 3rd and on my way to home. Here’s the final hammer for my point. The Value Trap Indicator has a great track record at predicting bankruptcies.
This is not to say that every company with a high Value Trap Indicator has gone bankrupt, far from it. But consider that out of the 35 major bankruptcies since 1994, the Value Trap Indicator flashed a “Strong Sell” (over 800) on 33 of the 35. So it’s pretty damn good at keeping you out of bankruptcies.
The values for the Value Trap Indicator are as follows:
0 – 250: Strong Buy
251 – 800: Neutral
800 + : Strong Sell
The current Value Trap Indicator for RSH:
VTI (RSH 9/11/14) = 1132
I’m going to go out on a limb and say that RadioShack is in trouble. Their financials are gasping for air. The writing is on the wall.
I wish those last stubborn shareholders good luck.
**All Rights Reserved. Investing for Beginners 2014**
**Debt to Equity Ratio Example: RadioShack’s Demise**