With capital being one of the basic factors of production, companies need exogenous funds to finance their corporate expenses, run operations smoothly as well as expand the realm of their business. Among equity and debt – the two most common options used to boost a company’s future earnings – debt is more popular. This is perhaps due to the cheap and easy availability of debt over equity financing.
Many companies opt for debt financing to pursue their business operations. As long as they generate a higher rate of return compared to the interest rate they have to eke out, there’s no worry for shareholders. However, exorbitant debt financing can be dangerous and might even lead to bankruptcy.
This is because while debt brings with it the capacity to spend a little bit more, it also bears the burden of repayment with additional interest in the future.
Since, companies bearing large amount of debts are more prone to financial crisis, the amount of debt a company bears plays a crucial role in an investment decision.
This is where the concept of “leverage” comes in. Leverage simply indicates the level of debt a corporation carries at present. The higher the degree of leverage a company carries, the more risk it bears for its investors to get caught in a debt trap.
Historically, several leverage ratios have emerged as efficient tools to evaluate a company’s creditworthiness for potential equity investments. The most popular among them is the debt-to-equity ratio.
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 53 stocks that made it through the screen.
Teledyne Technologies, Inc. (TDY - Free Report) : The company is an industrial conglomerate. It pulled off average positive earnings surprise of 12.92% in the trailing four quarters and currently sports a Zacks Rank #1.
Manulife Financial Corp. (MFC - Free Report) : It is one of the three dominant life insurers within the 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 sports a Zacks Rank #1. 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.