Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that D.R. Horton, Inc. (NYSE:DHI) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
View our latest analysis for D.R. Horton
What Is D.R. Horton’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2022 D.R. Horton had US$5.71b of debt, an increase on US$5.26b, over one year. However, it does have US$2.39b in cash offsetting this, leading to net debt of about US$3.31b.
A Look At D.R. Horton’s Liabilities
Zooming in on the latest balance sheet data, we can see that D.R. Horton had liabilities of US$4.96b due within 12 months and liabilities of US$4.75b due beyond that. Offsetting this, it had US$2.39b in cash and US$318.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.00b.
While this might seem like a lot, it is not so bad since D.R. Horton has a huge market capitalization of US$34.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
D.R. Horton has a low net debt to EBITDA ratio of only 0.44. And its EBIT easily covers its interest expense, being 1k times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that D.R. Horton has been able to increase its EBIT by 28% in twelve months, making it easier to pay down debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if D.R. Horton can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, D.R. Horton reported free cash flow worth 17% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Our View
Happily, D.R. Horton’s impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. When we consider the range of factors above, it looks like D.R. Horton is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. For instance, we’ve identified 1 warning sign for D.R. Horton that you should be aware of.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
What are the risks and opportunities for D.R. Horton?
D.R. Horton, Inc. operates as a homebuilding company in East, North, Southeast, South Central, Southwest, and Northwest regions in the United States.
Rewards
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Trading at 37% below our estimate of its fair value
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Earnings are forecast to grow 2.26% per year
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Earnings have grown 35.5% per year over the past 5 years
Risks
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Significant insider selling over the past 3 months
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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