For any company, sufficient capital is one of the major requirements to run its operations smoothly. Since no company has an unlimited source of capital, they need to borrow funds to finance this capital either using debt or equity. And here comes the concept of leverage, which refers to the use of borrowed funds by companies in corporate finance.
It is imperative to mention in this context that while borrowing such funds, empirically, it has been observed that companies prefer debt financing over equity financing. 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 the 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.
Another perk of debt financing is that the interest on debt is tax deductible.
Nevertheless, one should always keep in mind that debt financing is not always desirable and remains a feasible option only as long as the companies succeed in generating a higher rate of return compared to the interest rate. Exorbitant debt financing might even lead to a corporation’s bankruptcy in the worst-case scenario.
It is for this reason that while choosing a safe-bet stock, a prudent investor should be aware of its debt level. If a stock is highly leveraged, which means it possesses considerably high debt, it is wise to avoid it.
Considering the aforementioned discussion, a low-leverage stock should find a place in an investor’s portfolio. For measuring this leverage, several ratios have been used historically. The debt-to-equity ratio is one of the most common among such 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 third-quarter earnings season approaching, 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 the 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 28 stocks that made it through the screen.
ScanSource ( SCSC Quick Quote SCSC - Free Report) : It serves North America as a value-added distributor of specialty technologies, including automatic identification and point-of-sale products, and business telephone products. The company delivered an earnings surprise of 27.9%, on average, in the trailing four quarters and carries a Zacks Rank #2 currently. Quanta Services ( PWR Quick Quote PWR - Free Report) : It is a leading national provider of specialty contracting services, and one of the largest contractors serving the transmission and distribution sector of the North American electric utility industry. The company currently holds a Zacks Rank #2 and delivered an earnings surprise of 17.20% in the trailing four quarters, on average. Watts Water Technologies ( WTS Quick Quote WTS - Free Report) : It designs, manufactures, and sells various water safety and flow control products for water quality, water conservation, water safety, and water flow control markets. The company came up with a four-quarter earnings surprise of 17.34%, on average, and has a Zacks Rank of 2. You can see . the complete list of today’s Zacks #1 Rank stocks here Suburban Propane Partners ( SPH Quick Quote SPH - Free Report) : It is engaged, through its subsidiaries, in the retail and wholesale marketing of propane and related appliances and services. Currently, the company holds a Zacks Rank of 2. It came up with a four-quarter earnings surprise of 10.60%, on average. Darling Ingredients ( DAR Quick Quote DAR - Free Report) : It is a provider of rendering, cooking oil, and bakery waste recycling and recovery solutions. The company currently sports a Zacks Rank #1 and delivered a four-quarter earnings surprise of 39.12%, 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