Per the theory of cost of capital, a company’s capital structure reflects a mix of debt and equity that are used to finance its capital projects. Now a comparative analysis of the same theory reveals that most companies prefer debt financing over equity since debt is cheaper, especially in periods of low interest rates.
This is because when a company resorts to debt financing, it takes on 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 partial owner of the company but develops a direct claim on the company’s future profits as well. No doubt, debt financing is a popular financing option among the majority of corporations.
But debt financing has its share of drawbacks. The problem arises when leverage, referred to as the amount of debt a company bears, becomes exorbitant. A high degree of financial leverage means high interest payments, which affect the company's bottom-line growth.
Therefore, to safeguard one’s portfolio from notable losses, the real challenge for an investor is determining whether the organization’s debt level is sustainable as a debt-free corporation is rare to find. 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 implies that it has a more or less financially stable business, thereby making it a more worthy investment opportunity.
Therefore, before blindly pursuing high growth-yielding stocks, investors must consider their debt level. Since large debt loads can make a so-called growth stock volatile in times of economic crisis, it is better to go for stocks bearing low debt-to-equity ratio.
The Winning Strategy
In theory, the optimal capital structure for a company is one that offers the ideal debt-to-equity ratio that maximizes its value and minimizes its cost of capital. Since, in practice, screening stocks based on these criteria is a bit difficult, herein, we choose low leverage stocks as these are considered safe bets.
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 criteria, as discussed below.
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.
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 or 2 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.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 18 stocks that made it through the screen.
ePlus inc. (PLUS - Free Report) : It is an engineering-centric technology solutions provider that offers information technology (IT) products and services, flexible leasing and financing solutions, and enterprise supply management in the United States. The company carries a Zacks Rank #2 and came up with an average positive earnings surprise of 20.08% in the trailing four quarters.
Honda Motor Company, Ltd. (HMC - Free Report) : This company manufactures a wide range of products, including motorcycles, ATVs, generators, marine engines, lawn and garden equipment and automobiles. It carries a Zacks Rank # 1 and delivered an average positive earnings surprise of 69.20% in the trailing four quarters.
EMCOR Group, Inc. (EME - Free Report) : This corporation is engaged in design, integration, installation, start-up, testing, operation and maintenance of complex mechanical and electrical systems. It pulled off an average positive earnings surprise of 11.69% in the trailing four quarters and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Park Sterling Corporation (PSTB - Free Report) : It is engaged in providing banking products and services. The company carries a Zacks Rank #2 and came up with an average positive earnings surprise of 7.28% in the trailing four quarters.
Deutsche Post AG (DPSGY - Free Report) : It provides logistics services primarily in Germany, Europe, America, Asia Pacific and Other regions. The company carries a Zacks Rank #1 and delivered an average positive earnings surprise of 9.55% in the trailing four quarters.
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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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