Leverage is the use of borrowed funds by corporates for expansion of operations and amplifying possible returns from risk capital. Per the theory of cost of capital, a company’s capital structure reflects a mix of debt and equity that is used to finance capital projects.
However, historically, debt financing has been preferred over equity because of its easy and cheap availability.
Yet, debt financing has its share of drawbacks. In particular, when the amount of debt a company bears becomes exorbitant, debt financing turns into a burden. This is because a high degree of financial leverage means high interest payments, which affect the company's bottom line.
To this end, one should be aware of the fact that the stock market has become volatile ever since the deadly coronavirus struck across the globe around the end of March. Although the situation has improved to some extent, an entire rebound of the market to the pre-pandemic levels is highly unlikely in the near future.
Therefore, while choosing stocks, a prudent investor should avoid debt-ridden stocks as they bear high risk of solvency. Since a totally debt-free stock is hardly found, investing in a stock with comparatively lower debt level should a prudent choice forinvestors.
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 U.S. stock market still staggering to make a noticeable progress, investors must be eyeing stocks that have exhibited solid earnings growth historically. 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. : 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. VGM Score of A or B 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 17 stocks that made it through the screen.
LHC Group ( LHCG Quick Quote LHCG - Free Report) : LHC Group serves as a post-acute care partner for hospitals, physicians and families in the United States. The company delivered an earnings surprise of 22.34%, on average, in the trailing four quarters and currently sports a Zacks Rank #1. DICKS Sporting Goods ( DKS Quick Quote DKS - Free Report) : It operates as a major omni-channel sporting goods retailer, offering athletic shoes, apparel, accessories and a broad selection of outdoor and athletic equipment for team sports, fitness, camping, fishing, tennis, golf, water sports, etc.The company currently sports a Zacks Rank #1 and delivered an earnings surprise of 15.48% in the trailing four quarters, on average. Horace Mann Educators ( HMN Quick Quote HMN - Free Report) : It is a multiline insurance holding company that targets the U.S. educator market.The company came up with a four-quarter earnings surprise of 24.77%, on average, and carries a Zacks Rank #2. You can see . the complete list of today’s Zacks #1 Rank stocks here Arcosa ( ACA Quick Quote ACA - Free Report) : It is a manufacturer of infrastructure-related products and services, which serves construction, energy and transportation markets. Currently, the company holds a Zacks Rank #2 and came up with a four-quarter earnings surprise of 36.89%, on average. Lumber Liquidators Holdings ( LL Quick Quote LL - Free Report) : It is a retailer of hardwood flooring. It currently sports a Zacks Rank #1 and delivered a four-quarter earnings surprise of 432.50%, on average.
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