A company needs exogenous funds for smooth operations, to meet obligations and expand business. Depending solely on retained earnings for business growth is not possible. The two financial resources often resorted to are debt and equity.
A comparative analysis of the cost of capital theory reveals that most companies prefer debt financing over equity as debt is available at a lower cost compared to equity, especially in periods of low interest rates. Yet, the word “debt” is unnerving for many.
This is because while debt brings with it the capacity to spend a little bit more, it also carries the burden of repayment with additional interest in the future. The problem arises when leverage, referred to as the amount of debt a company bears, becomes exorbitant. In particular, companies with large debt loads are more vulnerable during economic downturns and can even go bankrupt in the worst case scenario.
Given the widespread uncertainty, no one can be fully sure of how a company will perform the next day. Companies bearing large amount of debts are more prone to financial crisis. Naturally, the amount of debt a company bears plays a crucial role in an investment decision.
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.
In general, investors target companies with solid earnings growth projections. But, in the uncertain world of investment, markets can trip anytime, particularly affecting companies with a higher degree of financial leverage. Therefore, blindly investing in stocks displaying solid earnings growth without considering their debt level is not a wise move.
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.
lululemon athletica inc. (LULU - Free Report) : The company is a yoga-inspired athletic apparel company that designs, manufactures and distributes athletic apparel for women and men. It pulled off average positive earnings surprise of 19.22% in the trailing four quarters and currently carries a Zacks Rank #2.
Manulife Financial Corp. (MFC - Free Report) : It is one of the three dominant life insurers within its domestic Canadian market. The company holds a Zacks Rank #2 and delivered average positive earnings surprise of 6.03% 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 an 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 carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
EMCOR Group Inc. (EME - Free Report) : It is one of the leading providers of mechanical and electrical construction, industrial and energy infrastructure, and building services for a diverse range of businesses. The company carries a Zacks Rank #2. It pulled off average positive earnings surprise of 19.12 % in the trailing four quarters.
MGIC Investment Corp (MTG - Free Report) : It is the leading provider of private mortgage insurance coverage to the U.S. 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.