Leverage refers to the investment strategy of using borrowed money —the use of borrowed capital — to run a business smoothly. In the complex world of investment, understanding the amount of financial leverage a company bears is crucial.
Although there remains an option to choose equity for borrowing capital, debt is the more popular one due to its cheap and easy availability over equity financing. Moreover, in case of equity financing, a shareholder not only becomes a partial owner of the company but also has a direct claim on the company’s future profits. So, debt financing remains more dearer for corporates.
Yet, 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.
Of course, this does not mean that corporations should totally avoid debt financing. In fact, it has been an inherent instrument for corporations to grow their earnings.
Nevertheless, to be on the safe side, investors try to avoid stocks that bear large debt loads. Empirically, several leverage ratios have been constructed to measure the exact amount of debt risk a company bears in order to safeguard investors from debt traps.
Debt-to-equity ratio is one such measure, perhaps the most popular one, which has been used 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 indicates improved solvency for a company.
With the Q4 earnings season knocking on the doors, investors must be targeting companies with solid earnings growth projections. But, in the uncertain world of investment, markets can falter 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 31 stocks that made it through the screen.
AbbVie Inc. (ABBV - Free Report) : It is a research-based biopharmaceutical company. The company generated an average positive earnings surprise of 3.54% in the last four quarters and currently carries a Zacks Rank #2.
HCA Healthcare, Inc. (HCA - Free Report) : It is the largest non-governmental operator of acute care hospitals in the United States. The company currently holds a Zacks Rank of 2 and delivered average positive earnings surprise of 11.22% over the trailing four quarters.
Steelcase Inc. (SCS - Free Report) : It offers a range of architecture, furniture and technology products and services designed to create high-performance work environments. The company came up with average positive earnings surprise of 21.87% in the preceding four quarters and sports a Zacks Rank #1 at present. You can see the complete list of today’s Zacks #1 Rank stocks here.
The Michaels Companies, Inc. (MIK - Free Report) : It is one of the leading arts and crafts specialty retailer in North America on the basis of store count. Currently, the company carries a Zacks Rank #2. It came up with average positive earnings surprise of 6.36% in the preceding four quarters.
The Boeing Company (BA - Free Report) : The company is a premier jet aircraft manufacturer and one of the largest defense contractors in the United States. It currently flaunts a Zacks Rank #1 and delivered average positive earnings surprise of 28.01% in the last 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.