Each and every company needs substantial amount of funds, technically referred to as capital, to run its operations smoothly and expand the same. Here comes the concept of leverage, which, in terms of corporate finance, refers to the use of borrowed capital since no company can run endlessly on its own funds.
Now this borrowed capital can be obtained by a firm either through debt or through equity. Empirically, it has been found that most companies prefer debt financing over equity financing 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.
Although the stock market has improved to some extent from the initial slump immediately after COVID-19 struck the world economy, any other uncertainty can once again disrupt that balance.
So, to avoid huge losses at times of crisis, a prudent investor should choose stocks that bear low leverage since a debt-free corporation is rare to find. Therefore, measuring the leverage level of a particular stock forms an integral part of a safe investment procedure.
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 year 2020 almost at its end, investors might be eyeing stocks that have exhibited solid earnings growth year to date. 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 or 2 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.
Procter & Gamble ( PG Quick Quote PG - Free Report) : It is a branded consumer products company, which markets its products in more than 180 countries primarily through mass merchandisers, grocery stores, membership club stores, drug stores, department stores, distributors, baby stores, specialty beauty stores, e-commerce, high frequency stores and pharmacies. The company delivered an earnings surprise of 9.24%, on average, in the trailing four quarters and currently carries a Zacks Rank #2. MarineMax ( HZO Quick Quote HZO - Free Report) : It is the United States’ largest recreational boat and yacht retailer. The company currently has a Zacks Rank #2 and delivered an earnings surprise of 263.62% in the trailing four quarters, on average. 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 came up with a four-quarter earnings surprise of 14.95%, on average, and carries a Zacks Rank #2. You can see . the complete list of today’s Zacks #1 Rank stocks here Quanex Building Products Corporation ( NX Quick Quote NX - Free Report) : It designs and produces energy-efficient fenestration products in addition to kitchen and bath cabinet components. Currently, the company sports a Zacks Rank #1. It came up with a four-quarter earnings surprise of 55.81%, on average. Cooper Tire & Rubber Company ( CTB Quick Quote CTB - Free Report) : It manufactures, markets and sells tires of a wide range of vehicles, including truck and bus radials as well as motorcycles. It currently sports a Zacks Rank #1 and delivered a four-quarter earnings surprise of 106.84%, on average.
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