Leverage is something that constitutes an integral part of running a business. But failing to understand its complexities can prove to be detrimental. 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.
However, resorting to debt is still considered a taboo as it carries the burden of interest payments.
In this context, it is imperative to note that the debt scenario in the United States is quite disturbing at this moment. Huge spending on wars, big tax cuts and stimulating economic programs have all added to the nation’s burden over the years. The Congressional Budget Office estimates that the debt held by the public will rise to 150% of the economy’s GDP in 2047 from 77% currently.
Nevertheless, this should not shift investor attention from U.S. stocks since debt has been part of the economy since its foundation and yet the country boasts the largest stock market in the world. What investors need to do is choose stocks with caution, avoiding those with high debt loads.
This is where the significance of financial leverage ratio comes into play as it measures the extent of financial leverage a company bears. To choose a corporation that is not so heavily indebted, several leverage ratios have been developed over the years, with the debt-to-equity ratio being the most popular.
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 shows improved solvency for a company.
Now investors must be eyeing companies that have exhibited solid earnings growth in recent times. But, in the uncertain world of investment, markets can falter, particularly affecting companies with a higher degree of financial leverage. Therefore, investing in stocks displaying solid earnings growth and not considering their debt level is not a wise move.
The Winning Strategy
Considering the aforementioned factors, it is prudent to choose stocks with a low debt-to-equity ratio to ensure steady 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.
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 or 2 have a proven history of success.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 28 stocks that made it through the screen.
Federal Signal Corporation (FSS - Free Report) : It is a leader in environmental and safety solutions. The company delivered average positive earnings surprise of 21.65% in the last four quarters and currently carries a Zacks Rank #2.
PCM, Inc. : It is a technology solutions provider serving businesses, government and educational institutions and individual consumers. The company currently holds a Zacks Rank of 2 and delivered average positive earnings surprise 27.40% for the last four quarters.
Amedysis, Inc. (AMED - Free Report) : It offers home health and hospice services throughout the United States to the growing chronic, co-morbid, and aging population. The company came up with average positive earnings surprise of 19.59% in the preceding four quarters and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Werner Enterprises, Inc. (WERN - Free Report) : It is a premier transportation and logistics company. Currently, the company carries a Zacks Rank #2. It came up with average positive earnings surprise of 11.25% in the preceding four quarters.
DMC Global Inc. (BOOM - Free Report) : The company is a diversified technology company. It currently carries a Zacks Rank #2 and delivered average positive earnings surprise of 48.24% 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.