Leverage is a well-known concept in the complex world of investment, which refers to the use of funds by companies to run their operations smoothly and expand the same. Since no company has an unlimited source of capital such funds are borrowed, either through equity financing or debt financing.
Among equity and debt, the two most common options used to boost a company's future earnings, the latter is the more popular one. This is perhaps due to the cheap and easy availability of debt over equity financing.
However, a company with too much of debt is not a desirable investment option. This is because, too much of debt brings with it the burden of interest payment.
Nevertheless, this should not discourage investors from spending on U.S. stocks since debt has been part of the economy since its foundation and yet the country is the biggest borrower worldwide. Empirically, the Congressional Budget Office estimates that federal debt will rise to 202% of the economy’s GDP by 2051.
So, a stock with debt on its balance sheet is not always undesirable. What investors need to do is choose stocks with caution, thus avoiding the ones that carry very high debt loads.
Here comes the significance of leverage, better to say financial leverage, which indicates the degree to which a company utilizes debt to boost its operations and earn escalated profit margins.
The next question is how to measure a company’s degree of financial leverage. To this end, several leverage ratios have been constructed as efficient tools to evaluate a company’s credit level to support prudent equity investments. The most popular among them is the debt-to-equity ratio.
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 second-quarter earnings season nearing its end, investors must be eyeing stocks that exhibited solid earnings growth in the recent past. 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.
Tractor Supply Company ( TSCO Quick Quote TSCO - Free Report) : It is the largest retail farm and ranch store chain in the United States.. The company delivered an earnings surprise of 22.59%, on average, in the trailing four quarters and carries a Zacks Rank #2 currently. Textron ( TXT Quick Quote TXT - Free Report) : It is a global multi-industry company that manufactures aircraft, automotive engine components and industrial tools. The company currently sports a Zacks Rank #1 and delivered an earnings surprise of 37.41% in the trailing four quarters, on average. Horace Mann Educators Corporation ( HMN Quick Quote HMN - Free Report) : It is a multiline insurance holding company that targets the U.S. educator market. The company came up with a four-quarter earnings surprise of 21.12%, on average, and has a Zacks Rank of 2. You can see . the complete list of today’s Zacks #1 Rank stocks here Janus Henderson Group plc ( JHG Quick Quote JHG - Free Report) : It is an investment management company. Currently, the company holds a Zacks Rank of 2 and came up with a four-quarter earnings surprise of 17.81%, on average. Axcelis Technologies, Inc. ( ACLS Quick Quote ACLS - Free Report) : It is a leading producer of ion implantation equipment used in the fabrication of semiconductors. The company currently sports a Zacks Rank #1 and delivered a four-quarter earnings surprise of 28.89%, 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