Leverage is a well-known business strategy, which involves usage of borrowed funds to finance the purchase of inventory, equipment as well as other company assets. Companies can obtain such funds either using debt or equity.
Statistically, companies prefer debt over equity. This is because debt is available easily and is cheaper than equity financing. Moreover, in case of debt financing, notwithstanding whether the interest charges are from a loan or line of credit, the interest payments are tax deductible. However, in case of equity financing, a shareholder not only becomes a partial owner of the company but develops a direct claim on the company’s future profits as well.
Nevertheless, debt financing has its share of drawbacks. Especially, companies with large debt loads are more vulnerable during economic downturns and can even go bankrupt in the worst-case scenario. A high degree of financial leverage means high interest payments, which affect a company's bottom line.
Since existence of a debt-free company is rare, to safeguard their portfolio from notable losses, the real challenge for an investor is determining whether an organization’s debt level is sustainable. To gauge how risky a company is, potential equity investors look at leverage ratios. 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 shows improved solvency for a company.
With the Q2 reporting cycle approaching its end, investors must be eyeing companies that have exhibited solid earnings growth in the past couple of quarters. But, in the uncertain world of investment, markets can falter anytime, particularly affecting companies with a higher degree of financial leverage. Therefore, 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 prudent to choose stocks with a low debt-to-equity ratio to ensure steady 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. : 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. VGM Score of A or B 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 51 stocks that made it through the screen.
Herman Miller MLHR: The company is a major American manufacturer of office furniture, equipment and home furnishings. It delivered average positive earnings surprise of 7.02% in the last four quarters and currently carries a Zacks Rank #2. James River Group Holdings JRVR: It is an insurance company, which owns and operates specialty insurance and reinsurance companies. The company currently holds a Zacks Rank of 2 and delivered average positive earnings surprise of 2.62% in the last four quarters. Federal Signal ( FSS Quick Quote FSS - Free Report) : This company provides infrastructure maintenance equipment and public safety tools. It came up with average positive earnings surprise of 16.48% in the preceding four quarters and carries a Zacks Rank #1. You can see . the complete list of today’s Zacks #1 Rank stocks here TopBuild BLD: It is an installer and distributor of insulation products and serves the construction industry, primarily in the United States. Currently, the company holds a Zacks Rank #2. It came up with average positive earnings surprise of 10.45% in the preceding four quarters. SolarEdge Technologies SEDG: This company provides solar inverter solutions. It sports a Zacks Rank #1. It delivered average positive earnings surprise of 1.23% in the last four quarters.
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Disclosure: Performance information for Zacks’ portfolios and strategies are available at: . https://www.zacks.com/performance