This is a guest post from Ney Torres, with whom I had an interesting email exchange as we tried to figure out why Home Depot had negative equity.
Is negative equity bad? Most of the time, yes! But not always.
In fact, having negative equity can be a sign of an excellent company.
It took me a while to understand this because it is not obvious. Let me walk you through what I’ve come to learn.
What Negative Equity Usually Means
Negative equity, most of the time, means that a company’s liabilities are so high that (in theory) shareholders owe money to their lenders. A clear example of this happens when the real estate market crashes and the owner of the house owes more than what the house is worth. When this happens most people just walk away from their house and let the bank have it. This happened a lot in the crash of 2008.
Of course in stocks, you have limited liability as a shareholder, so nobody is going to come and knock your door to collect their debt or ruin your credit rating. But it would mean you lost your investment… Or would it?
Except that some great companies also show negative equity, like what just happened to Home Depot ($HD).
The stock price keeps going up but equity in the company is dropping like a rock.
Great Companies with Negative Equity
Take a quick look at the financials, however.
Revenue is growing, net income is up, profitability is as high it has ever been, etc., etc. A great company!
Then why does Home Depot have negative equity?
Buybacks Can Result In Negative Equity
Turns out that if you take a closer look at the financial statements, there’s a line called “Treasury Stock” and this line is negative. Very negative!
This is where the company puts all the stock they buy back in the open market (or it may have never been issued to the public in the first place).
These shares don’t pay dividends, have no voting rights, and are NOT included in the share outstanding calculations. In fact, management can decide to destroy these shares.
And that’s why, my friends, great companies can have negative equity.
Is Buyback-Driven Negative Equity A Positive?
We already know about the benefits of buybacks as a return of capital to shareholders through commensurate increases in share price (gains that aren’t taxed at the time unlike dividends).
But we do have to make sure this isn’t impacting the health of the company. It’s worth checking the state of the company’s debt and its return on invested capital (ROIC).
In HD’s case, their long-term debt has grown by a little over $18B in the last 10 years. That’s a little less than the $20.5B by which its Total Equity has been reduced in the same timeframe.
I don’t necessarily love companies funding buybacks by taking on debt, so the first thing I’ll do is look at their ROIC.
ROIC stands for returns on invested capital, and if you’re trading out equity for debt, your total amount of invested capital stays the same. But you need to be earning much more than your cost of capital (which in Home Depot’s case is now entirely based on its cost of debt).
Wow! With a ROIC of nearly 50% in the trailing twelve months, HD is in no danger of not earning back its cost of capital (which is about 8%). A 50% ROIC is pretty incredible.
I do worry about continued buybacks as their stock gets more expensive — it’s at or near 10-15-year highs on EV/EBITDA, EV/EBIT, and P/E.
When a company has a lot of debt, you should just check on its solvency to make sure it’s not in trouble. Typical Debt/Equity ratios make no sense in a negative equity world, so skip those.
In HD’s case, its Current and Quick Ratios are pretty low — its ability to cover its current liabilities with its current assets is there, but not by a lot.
I guess you could consider this as being extremely efficient, but almost too efficient!
The good news is that HD is a free cash flow machine. It can cover its total debt in less than 3 years of its FCF. That seems pretty safe to me.
Negative Equity Opportunity
So, HD’s negative total equity doesn’t seem like a problem. Because of the way a lot of people look at companies, having negative equity will often screen potential stocks out.
Any metric based on equity will basically break and make the stock look bad. But, as we can see, this isn’t always the case, so looking for companies with negative equity due to negative treasury stock could be a big opportunity.