Companies are in constant need for funds to run their operations smoothly. These funds, arranged by companies through borrowing, are referred to as leverage. Now such borrowings can be done either in terms of debt financing or equity financing.
However, empirically, we have witnessed that debt financing is more popular in corporate finance 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.
Nevertheless, 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.
Meanwhile, it is imperative to mention that with the global economy still topsy-turvy, thanks to the coronavirus pandemic, investors should be extra 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 since a debt-free corporation is rare to find. So, it is necessary for an investor is to measure the debt level of a company and understand whether its debt level is sustainable or not.
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 Q3 reporting cycle almost over for 2020, investors must be 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. 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. VGM Score of A or 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 13 stocks that made it through the screen.
Titan Machinery ( TITN Quick Quote TITN - Free Report) : It owns and operates a network of over 70 full-service agriculture and construction equipment stores across the United States and six countries in Europe. At its stores, the company sells new and used construction and farm equipment, as well as offer construction rental equipment. The company delivered an earnings surprise of 349.16%, on average, in the trailing four quarters and currently sports a Zacks Rank #1. Saia, Inc. ( SAIA Quick Quote SAIA - Free Report) : It is a leading transportation company that provides a variety of trucking transportation and supply chain solutions to a broad range of industries, including the retail, petrochemical and manufacturing industries. The company currently has a Zacks Rank #2 and delivered an earnings surprise of 14.95% in the trailing four quarters, on average. Boise Cascade ( BCC Quick Quote BCC - Free Report) : It operates as a wood products manufacturer and building materials distributor. The company came up with a four-quarter earnings surprise of 48.19%, on average, and carries a Zacks Rank #2. You can see . the complete list of today’s Zacks #1 Rank stocks here Addus Homecare Corporation ( ADUS Quick Quote ADUS - Free Report) : It is a comprehensive provider of a broad range of social and medical services in the home. Currently, the company carries a Zacks Rank #2 and came up with a four-quarter earnings surprise of 26.79%, on average. The ODP Corporation ( ODP Quick Quote ODP - Free Report) : It is one of the leading providers of business services, products and digital workplace technology solutions through an integrated B2B distribution platform. It currently sports a Zacks Rank #1 and delivered a four-quarter earnings surprise of 3.05%, on average.
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