In the theory of finance, leverage refers to the use of borrowed funds,which companies invest in their business in expectation of generous returns. This borrowing can be done through debt financing or equity financing.
Empirically, debt financing has achieved more popularity when compared to equity financing.
This is because, on availing debt financing, the company’s equity does not get diluted as a result of issuing more shares of the stock. In other words, the borrower has no claim in the company’s shares.
Another perk of debt financing is that the interest on debt is tax deductible.
However, one should keep in mind that debt financing remains a feasible option as long as the companies succeed in generating a higher rate of return compared to the interest rate. Exorbitant debt financing might even lead to a corporation’s bankruptcy in a worst case scenario.
Moreover, as the global economy is still topsyturvy, thanks to the coronavirus pandemic, investors should be even more careful while choosing stocks. This gives investors all the more reasons to be acquainted with leverage.
Considering the aforementioned discussion, one can safely invest in a stock as long as it bears a low level of debt.
Historically several leverage ratios have been developed to measure the amount of debt a company bears and the debt-to-equity ratio is one of the most common ratios.
Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity
This metric is a liquidity ratio that indicates the amount of financial risk a company bears. A company with a lower debt-to-equity ratio shows improved solvency for a company.
With the Q2 reporting cycle almost over, investors mustbe eyeing stocks that exhibited solid earnings growth in the prior quarters. But if a stock bears a high debt-to-equity ratio, in times of economic downturns, its so-called booming earnings picture might turn into a nightmare.
The Winning Strategy
Considering the aforementioned factors, it is prudent to choose stocks with a low debt-to-equity ratio to ensure steady returns.
However, an investment strategy based solely on debt-to-equity ratio might not fetch the desired outcome. To choose stocks that have the potential to give you steady returns, we have expanded our screening criteria to include some other factors.
Here are the other parameters:
Debt/Equity less than X-Industry Median: Stocks that are less leveraged than their industry peers.
Current Price greater than or equal to 10: The stocks must be trading at a minimum of $10 or above.
Average 20-day Volume greater than or equal to 50000: A substantial trading volume ensures that the stock is easily tradable.
Percentage Change in EPS F(0)/F(-1) greater than X-Industry Median: Earnings growth adds to optimism, leading to a stock’s price appreciation.
VGM Score of A or B: Our research shows that stocks with a VGM Score of A or B when combined with a Zacks Rank #1 (Strong Buy) or 2 (Buy) offer the best upside potential.
Estimated One-Year EPS Growth F(1)/F(0) greater than 5: This shows earnings growth expectation
Zacks Rank #1 or 2: Irrespective of market conditions, stocks with a Zacks Rank #1 (Strong Buy) or 2 (Buy) have a proven history of success.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 32 stocks that made it through the screen.
Kinsale Capital Group (KNSL - Free Report) : It offers various insurance and reinsurance products across all 50 states of the United States, the District of Columbia, the Commonwealth of Puerto Rico and the U.S. Virgin Islands. The company delivered an earnings surprise of 7.99%, on average, in the trailing four quarters and currently carries a Zacks Rank #2.
American States Water Company (AWR - Free Report) : It along with its subsidiaries provides fresh water, wastewater services and electricity to its customers in the United States.The company currently has a Zacks Rank #2 and delivered an earnings surprise of 0.15% in the trailing four quarters, on average.
Gibraltar Industries (ROCK - Free Report) : It manufactures and distributes products to the industrial and buildings market. The company’s products range from ventilation and expanded metal to mail storage solutions and rain dispersion products and solutions.The company came up with a four-quarter earnings surprise of 37.83%, on average, and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
D.R. Horton (DHI - Free Report) : It is one of the leading national homebuilders, primarily engaged in the construction and sale of single-family houses both in the entry-level and move-up markets. Currently, the company sports a Zacks Rank #1 and came up with a four-quarter earnings surprise of 16.78%, on average.
West Pharmaceutical Services (WST - Free Report) : It operates as a global drug delivery technology company. It currently holds a Zacks Rank #2 and delivered a four-quarter earnings surprise of 21.42%, on average.
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.