“Every time you borrow money, you’re robbing your future self.” – Nathan W. Morris

Of course, since capital is one of the basic requirements of production, companies – especially those with a dearth of resources – often resort to debt financing to boost up their future earnings. This is because equity financing is relatively costlier. Another perk to debt financing is that the interest expense is tax deductible.

However, for a safe investment strategy, understanding the amount of financial leverage that a company bears is crucial. This is because financial leverage multiplies the underlying business risk. So, while financial leverage brings with it the expectation of increased return in the future, it also carries the risk of losing money substantially. In fact, in any unfavorable turn of events, exorbitant debt financing bears the risk of dragging a company into bankruptcy.

For the purpose of safe investment in stocks, varied parameters based on leverage ratio have been constructed historically. These parameters serve the purpose of estimating the credit worthiness of a company. One such prominent tool is debt-to-equity ratio.

What is Debt-to-Equity Ratio?

Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity

In simple terms, debt-to-equity is a solvency ratio that measures a company’s debt position and its ability to pay interest. A lower debt-to-equity ratio greatly contributes to an investor’s confidence in a company’s financial stability.

This is because a high debt-to-equity ratio indicates a huge level of repayment that the company has to make in connection with the large debt amount, which had once exploded its earnings. This in reality, makes the company’s so-called solid earnings extremely volatile.

Choose the Right Strategy

Instead of blindly targeting high earnings yielding stocks, it is wise for investors to pour money in low leverage stocks.

However, choosing stocks based solely on one financial metric might not fetch the desired outcome. To ensure maximum possible return from this strategy, we have expanded our screening procedure to include some other criteria.

Here is the final screen:

Debt/Equity less than X-Industry Median: Those 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.

Estimated One-Year EPS Growth F(1)/F(0) greater than 5: This shows earnings growth expectation.

Zacks Rank #1 (Strong Buy) or #2 (Buy): No matter whether market conditions are good or bad, stocks with a Zacks Rank #1 (Strong Buy) or 2 (Buy) have a proven history of success.

VGM Score of A or B: Our research shows that stocks with a VGM Score of ‘A’ or ‘B’ when combined with a Zacks Rank #1 or 2 offer the best upside potential. 

Although 35 stocks passed the screen, we have eliminated those with a negative or a zero debt-to-equity ratio.  

Here are five stocks from the final 19:

Omega Protein Corporation : This nutrition products supplier, with a special focus in fish meal products, currently holds a Zacks Rank #1 and witnessed a 3.8% improvement in its current year consensus estimate in the last 60 days.

NTT DOCOMO, Inc. : This mobile communications services provider, which carries a Zacks Rank #2, witnessed a 10.8% improvement in its current year consensus estimate in the last 60 days.

Amphastar Pharmaceuticals, Inc. (AMPH Quick QuoteAMPH - Free Report) : This special pharmaceutical company, which sports a Zacks Rank #1, witnessed a strong improvement in its current-year consensus estimate in the last 60 days to earnings of 5 cents per share from a loss of 6 cents.

Comfort Systems USA Inc. (FIX Quick QuoteFIX - Free Report) : This general contracting services provider holds a Zacks Rank #2 and witnessed a 7.7% improvement in its current year consensus estimate in last 60 days.

Universal Forest Products Inc. (UFPI Quick QuoteUFPI - Free Report) : This wood and wood-alternative product manufacturer currently carries a Zacks Rank #2 and its long-term expected earnings growth rate is 10%, higher than industry average of 5.8%.

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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.

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