In corporate finance, leverageis the use of exogenous funds by corporations to run their operations smoothly and expand the same. While there is option for equity financing, historically debt financing has been preferred over equity.
This is because debt is available easily and is cheaper compared with equity financing. However, one should keep in mind that debt financing remains a feasible option 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 a worst case scenario.
Especially, in times of crisis, no one can be fully sure of how a company will perform the next day. On top of that, the ones bearing large amount of debt are even more prone to bankruptcy. Therefore, the debt level of a company is an important point of consideration while making an investment decision.
Considering the fact that uncertainty can hit the share market anytime, it is better to take measures beforehand than repent later. This is why investors needs to look for stocks that are relatively less leveraged, since a corporation with zero debt hardly exists.
And here comes the importance of leverage ratios, which have been constructed to safeguard investors from becoming victims of debt trap. Debt-to-equity ratio is one such measure, perhaps the most popular one, to evaluate a company’s creditworthiness 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 indicates improved solvency for a company.
Although companies reflecting high earnings growth should be ideal investment choices, those with high leverage may not generate satisfactory returns. Since a greater cohort of investors is risk-averse by nature, it is reasonable to expect that they will be more attracted to companies with low leverage than high earnings growth.
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 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.
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 (Strong Buy) or 2 (Buy) offer the best upside potential.
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 59 stocks that made it through the screen.
OGE Energy Corp. (OGE - Free Report) : The company is Oklahoma's largest electric utility. It pulled off average positive earnings surprise of 17.18% in the trailing four quarters and currently carries a Zacks Rank #2.
Amedysis, Inc. (AMED - Free Report) : It provides home health and hospice services throughout the United States to the growing chronic, co-morbid and aging American population. The company holds a Zacks Rank #2 and delivered average positive earnings surprise of 16.55% in the trailing four quarters.
Athene Holding Ltd (ATH - Free Report) : It operates as a retirement services company that issues, reinsures and acquires retirement savings products designed for the increasing number of individuals and institutions seeking to fund retirement needs.The company pulled off average positive earnings surprise of 17.37% in the trailing four quarters and currently sports a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
Teledyne Technologies Inc. (TDY - Free Report) : It is an industrial conglomerate. The company sports a Zacks Rank #1. It pulled off average positive earnings surprise of 12.92 % in the trailing four quarters.
MGIC Investment Corp (MTG - Free Report) : It is the leading provider of private mortgage insurance coverage in the United States to the home mortgage lending industry. The company currently holds a Zacks Rank #2 and delivered average positive earnings surprise of 34.32% 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.