Equity investors often look for stocks that have historically exhibited solid growth trends. However, one must be well aware about the chosen stocks’ debt levels since a debt-ridden stock might not perform well over the long run, even if it has recorded solid growth in the recent past.
Here comes the concept of leverage, which refers to the use of exogenous funds by companies to run their operations smoothly and expand the same. It is imperative to mention in this context that although there is option for equity financing, majority of companies opt for debt financing to obtain such exogenous funds.
However, the level of debt financing plays a crucial role in a stock’s performance because if too much debt is opted for by a company there lies the risk of default. This is because debt financing means borrowing against future earnings, which simply means that instead of using all future profits to grow the business, one has to allocate a portion for repayments.
So, for a prudent investor, a safe strategy of choosing stocks should also include search for stocks that bear low leverage, apart from other factors. Therefore, measuring the leverage of a particular stock forms an integral part of the safe investment procedure.
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 this year’s first-quarter reporting cycle already past the halfway mark, 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.
DAQO New Energy Corp. ( DQ Quick Quote DQ - Free Report) : It is engaged in the manufacture and sale of high-quality polysilicon to photovoltaic product manufacturers. The company has an earnings surprise of 160.70%, on average, in the trailing four quarters and sports a Zacks Rank #1 currently. Louisiana Pacific 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 currently sports a Zacks Rank #1 and delivered an earnings surprise of 40.47% 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 46.15%, on average, and sports a Zacks Rank of 1. You can see . the complete list of today’s Zacks #1 Rank stocks here West Pharmaceutical Services ( WST Quick Quote WST - Free Report) : It is a global drug delivery technology company and is the world's premiere provider of standard-setting systems and device components for parenterally administered medicines. Currently, the company carries a Zacks Rank of 2 and came up with a four-quarter earnings surprise of 28.54%, on average. PulteGroup Inc. ( PHM Quick Quote PHM - Free Report) : It engages in homebuilding and financial services businesses, primarily in the United States. It currently holds a Zacks Rank #1 and delivered a four-quarter earnings surprise of 18.29%, on average.
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. Click here to sign up for a free trial to the Research Wizard today Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. Disclosure: Performance information for Zacks’ portfolios and strategies are available at: . https://www.zacks.com/performance