In the complex world of investment, understanding the amount of financial leverage a company bears is crucial. With capital being one of the basic factors of production, companies — especially those facing a dearth of resources — 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, the latter is the more popular one. This is perhaps due to the cheap and easy availability of debt over equity financing.
In fact, statistics indicate that the United States, the richest economy in the world, is the biggest borrower. Notably, 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 federal debt will rise to 92% of the economy’s GDP in 2029 from 78% currently.
Nevertheless, this should not discourage investors from spending on U.S. stocks since debt has been part of the economy since its foundation and yet the country leads others. What investors need to do is choose stocks with caution, thus avoiding the ones that carry high debt loads.
Here comes the significance of leverage, better to say financial leverage, which indicates the degree to which a company utilizes debt to boost its operations and earn escalated profit margins. Usually investors tend to avoid companies bearing a higher degree of financial leverage to avoid falling into debt traps.
The next question is how to measure a company’s degree of financial leverage. To this end, several leverage ratios have been constructed as efficient tools to evaluate a company’s credit level to support prudent 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 shows improved solvency for a company.
With the Q3 reporting cycle gaining steam recently, an investor must be looking for solid growth stocks. However, blindly investing in stocks displaying solid earnings growth, without considering their debt level, might not be a wise move. As uncertainty can hit the global equity market any time, it is reasonable to expect that investors will be more attracted to companies with low leverage than high earnings growth.
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 have a proven history of success.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 21 stocks that made it through the screen.
Manulife Financial (MFC - Free Report) : The company is one of the three dominant life insurers in Canada. It delivered average positive earnings surprise of 4.95% in the last four quarters and currently carries a Zacks Rank #2.
Gibraltar Industries (ROCK - Free Report) : 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% for the last four quarters.
Caseys General Stores (CASY - Free Report) : It is a chain of convenience stores. It came up with average positive earnings surprise of 30.15% in the preceding four quarters and holds a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Steelcase : The company is a designer and manufacturer of products used to create high-performance work environments. Its product portfolio includes furniture systems, seating, storage, desks, casegoods, interior architectural products. Currently, the company sports a Zacks Rank #1. It came up with average positive earnings surprise of 6.69% in the preceding four quarters.
Career Education Corporation : It is an educational services company. It sports a Zacks Rank #1. It delivered average four-quarter positive earnings surprise of 20.66%.
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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.