Leverage is a common practice in corporate finance, which refers to the use of exogenous funds by companies to run their operations smoothly and expand the same. Now, companies can obtain these exogenous funds either through equity financing or debt financing.
Statistically, it is found that debt financing is preferred over equity because of its easy and cheap availability.
However, debt financing has its own share of drawbacks. Particularly, it is desirable only as long as it successfully generates a higher rate of return compared to the interest rate. So, to avoid considerable losses in your portfolio, one should always avert companies that resort to exorbitant debt financing.
Therefore, the crux of safe investment lies in choosing a company that is not overtly burdened with debt as a debt-free stock is almost impossible to be found.
To identify such stocks, 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 fourth quarter reporting cycle almost in its last lap, investors might be eyeing stocks that have exhibited solid earnings growth in recent 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. : 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 29 stocks that made it through the screen.
MarineMax, Inc. ( HZO Quick Quote HZO - Free Report) : It is the United States’ largest recreational boat and yacht retailer. The company has an earnings surprise of 99.89%, on average, in the trailing four quarters and a Zacks Rank #2, currently. Quanex Building Product Corporation ( NX Quick Quote NX - Free Report) : It is a manufacturer of components like energy-efficient fenestration products in addition to kitchen and bath cabinet components that are sold to Original Equipment Manufacturers in the building products industry. The company currently has a Zacks Rank #1 and an earnings surprise of 55.81% in the trailing four quarters, on average. LouisianaPacific Corporation ( LPX Quick Quote LPX - Free Report) : It is a leading manufacturer of sustainable, quality engineered wood building materials, structural framing products as well as exterior siding for use in residential, industrial and light commercial construction. The company came up with a four-quarter earnings surprise of 41.54%, on average, and sports a Zacks Rank of 1. You can see . the complete list of today’s Zacks #1 Rank stocks here STMicroelectronics N.V. ( STM Quick Quote STM - Free Report) : It is a global independent semiconductor company, which designs, develops, manufactures and markets a broad range of semiconductor integrated circuits and discrete devices. Currently, the company carries a Zacks Rank of 2 and came up with a four-quarter earnings surprise of 1.24%, on average. Franklin Electric Co., Inc. ( FELE Quick Quote FELE - Free Report) : It is a global leader in the production and marketing of systems and components for the movement of water and automotive fuels. It currently holds a Zacks Rank #2 and delivered a four-quarter earnings surprise of 19.15%, on average.
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