Leverage is a well-known business strategy of using borrowed funds to finance the purchase of inventory, equipment as well as other company assets. These funds can also be utilized to pay back the company’s prior debt. Companies can obtain such funds either using debt or equity.
Statistically, companies prefer debt over equity. This is because debt is easily available and 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.
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 a company's bottom line.
Since a debt-free corporation is almost impossible to find, choosing a less debt-ridden stock should be an appropriate option for a risk-averse investor. And here comes the importance of leverage ratios, which can measure the exact amount of debt risk a company bears. 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.
Investors must be looking for stocks exhibiting solid earnings growth in the last couple of quarters. However, 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 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. : 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 have a proven history of success.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 54 stocks that made it through the screen.
Federal Signal Corporation FSS: The company provides infrastructure maintenance equipment and public safety tools. It delivered average positive earnings surprise of 16.48% in the last four quarters and currently sports a Zacks Rank #1. Gibraltar Industries ROCK: It is a leading manufacturer and distributor of building products for the industrial, infrastructure and residential markets. The company currently holds a Zacks Rank of 2 and delivered average positive earnings surprise 0.01% inthe last four quarters. Chemed Corp. ( CHE Quick Quote CHE - Free Report) : It is the largest provider of end-of-life hospice care services in the United States. It came up with average positive earnings surprise of 30.26% in the preceding four quarters and sports a Zacks Rank #1. You can see . the complete list of today’s Zacks #1 Rank stocks here FTI Consulting FCN: The company is a global business advisory firm. Currently, the company sports a Zacks Rank #1. It came up with average positive earnings surprise of 70.83% in the preceding four quarters. L3Harris Technologies LHX: The company is an agile aerospace and defense technology innovator, providing advanced defense and commercial technologies across air, land, sea, space and cyber domains. It sports a Zacks Rank #1. It delivered average positive earnings surprise of 4.21% 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