Debt financing is a common practice among corporates to ensure smooth operations and business expansion. This is because depending solely on retained earnings for business growth is impracticable.
Although companies may raise capital through equity financing, debt financing has always been a favored choice. While debt financing brings with it the liability of interest payment, it provides funding at lower rates than equity financing, especially in periods of historically low interest rates. Another perk of debt financing is that the interest on debt is tax deductible.
Yet, debt financing has its drawbacks. Since too much debt increases the cost of capital for the company, bearing huge debt tends to shoot up the company’s risk of bankruptcy, especially in times of economic crisis.
With the Federal Reserve having raised their benchmark interest rate last December and two more hikes expected by analysts this year, the debt scenario does not seem very favorable for U.S. stocks.
The fact that only a fortunate few can avoid taking debt, should not dissuade investors from betting on stocks. Instead, a prudent investor will try to pick stocks that are less financially leveraged as companies with high debt load are risky options.
And here comes the importance of leverage ratios, which have been constructed historically to save investors from debt traps. The debt-to-equity ratio is one such measure, perhaps the most popular one, to evaluate a company’s credit worthiness, for potential equity investments.
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 better investment pick.
With the Q4 reporting cycle about to begin, investors will tend to target stocks exhibiting solid earnings growth.
But choosing stocks that boast earnings growth only might not be a wise investment strategy. A higher degree of leverage can turn an attractive investment option into a nightmare in times of financial crisis.
The Winning Strategy
Considering the aforementioned factors, it is wise to choose stocks with a low debt-to-equity ratio to ensure safe 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.
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): Irrespective of market conditions, 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 21 stocks that made it through the screen.
Rice Midstream Partners LP : This is a midstream energy company that owns, operates, develops and acquires midstream assets in the Appalachian Basin. It pulled off an average positive earnings surprise of 35.25% in the trailing four quarters and carries a Zacks Rank #1.
Jacobs Engineering Group Inc. (JEC - Free Report) : The company is one of the world's largest and most diverse providers of technical, professional, and construction services, including all aspects of architecture, engineering and construction, operations and maintenance, as well as scientific and specialty consulting. It carries a Zacks Rank #2 and has delivered an average positive earnings surprise of 9.65% in the trailing four quarters.
Lam Research Corporation (LRCX - Free Report) : It provides market-leading equipment and services for semiconductor wafer processing. It pulled off an average positive earnings surprise of 5.33% 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.
Diplomat Pharmacy, Inc. (DPLO - Free Report) : It operates as an independent specialty pharmacy in the United States, which aids in the dispensing, delivery, dosing and reimbursement of clinically intensive and specialty drugs. The company carries a Zacks Rank #1 and pulled off an average positive earnings surprise of 27.50% in the trailing four quarters.
Forward Air Corporation (FWRD - Free Report) : This company provides ground transportation and related logistics services to the North American air freight and expedited LTL market. It sports a Zacks Rank #2 and has delivered an average positive earnings surprise of 8.47% 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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