Leverage is a well-known business strategy to use borrowed funds for financing the purchase of inventory, equipment and other company assets. These funds can also be utilized to repay the company’s prior debt. Companies can obtain such funds either using debt or equity.
Historically, debt financing has been preferred over equity. This is because when a company resorts to debt financing, it incurs fixed expenses in the form of interest payments for a specific time period. However, in case of equity financing, a shareholder not only becomes a company’s partial owner but also gets entitled to a direct claim to its future profits.
Nevertheless, debt financing is not always actually profitable. Particularly, one should keep in mind that debt financing is 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 cause a corporation’s bankruptcy in a worst-case scenario.
A high degree of financial leverage means heavy interest payments, which affect a company's bottom line.
Therefore, one should always consider measuring the debt level of a stock before adding it to one’s portfolio.
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 first-quarter reporting cycle set to start investors might be eyeing stocks that have exhibited solid earnings growth in the 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.
Herc Holdings Inc. ( HRI Quick Quote HRI - Free Report) : It is an equipment rental supplier in North America. The company has an earnings surprise of 85.40%, on average, in the trailing four quarters and sports a Zacks Rank #1 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 sports a Zacks Rank #1 and delivered an earnings surprise of 652.91% in the trailing four quarters, on average. Nucor Corporation ( NUE Quick Quote NUE - Free Report) : It is a leading producer of structural steel, steel bars, steel joists, steel deck and cold finished bars in the United States. The company came up with a four-quarter earnings surprise of 46.72%, on average, and sports a Zacks Rank of 1. You can see . the complete list of today’s Zacks #1 Rank stocks here Titan Machinery Inc. ( TITN Quick Quote TITN - Free Report) : It is a renowned dealer of of agricultural, construction, and consumer products. Currently, the company carries a Zacks Rank of 2 and came up with a four-quarter earnings surprise of 345.83%, on average. Deckers Outdoor Corporation ( DECK Quick Quote DECK - Free Report) : It is a leading designer, producer, and brand manager of innovative, niche footwear and accessories developed for outdoor sports, and other lifestyle-related activities. It currently holds a Zacks Rank #2 and delivered a four-quarter earnings surprise of 485.05%, on average.
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