Is negative equity bad in stocks?

Is negative equity bad in stocks?

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 is not obvious.

Negative equity, most of the time, means that your 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 the bank more than what the house is worth. When this happens most people just walk away from their houses and let the bank have the house; this is what happened to many people in the crash of 2008.

Of course, in stocks you have limited liability as a shareholder, so nobody is going to come and knock on your door to collect their debt. It would mean you lost your investment... Or does it?

Except that some great companies also show negative equity; for example, it just happened to Home Depot HD.

The stock price keeps going up but equity in the company is dropping like a rock.

Take a quick look at the financials. Revenue is growing, their operating margins are as high as they have ever been, etc. It’s a great company!

So why does Home Depot have negative equity?

Turns out that if you take a closer look to the financial statements, there's a line called "Treasury Stocks" and this line is negative!

Here 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 this shares.

And that's why my friends, great companies can also have negative equity. It is actually an admirable feat, by management, if shares are bought cheaply enough (compared to the value).

Why? Because the investors that stay are becoming richer! This is much better than paying dividends, because you don't get taxed! And every share has a multiple in the stock market. For example, right now, HD’s PE ratio (price over earnings) is 23.33. For every dollar your stock produces you can sell it for $23.33.

Note: try to compare cost of capital (WACC) vs the return on invested capital (ROIC).

Home Depot's weighted average cost of capital is 7.99%. The Home Depot's ROIC % is 44.86% 

That means that they produce an extra $44.86 with every $100 they take. And it only costs them $7.99.

You have to be careful with any metric based on equity because the stock looks bad; when it hits negative equity these calculations just break.

How many stocks have negative equity today?

2186

How many companies have negative equity, but are not going broke?

(I scanned equity-assets of max 0, and a current ratio of 1 and up).

521

How many good companies are out there?

(I scanned equity-assets of max 0, 10y median ROA of 10%+  and a current ratio of 1 and up).

15

So we can conclude it is not a very common subject for one to come across with. I hope that this helps.

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