In the complex world of investment, understanding the amount of financial leverage a company bears is crucial. Notably, leverage refers to a well-known business strategy in corporate finance, which involves usage of borrowed capital by companies to ensure smooth run of operations and expansion of the same. In simple words, it is the amount of debt a firm uses to invest in its business operations.
Now, one may ask why a company chooses debt when the option of equity financing exists. The answer is simple. Debt is a much cheaper form of financing than equity. Moreover, payments on debt are tax deductible. So, the majority of companies resort to debt financing.
Yet, debt financing has its share of drawbacks. Particularly, the fact that debt carries the burden of interest payments makes it dearer. Nevertheless, it is next to impossible to find a company that is free of debt. So, one should look for stocks that bear considerably low rate of debt. This is because exorbitant debt financing might even cause a corporation to become bankrupt in times of economic downturns.
Therefore, to protect one’s portfolio from notable losses, the real challenge for an investor is to ascertain if an organization’s debt level is sustainable. Historically, several leverage ratios are developed to measure the amount of debt a company bears and the debt-to-equity ratio is one of the most common of those ratios.
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 on the lookout for stocks that exhibited solid earnings growth in the last couple of quarters. However, blindly investing in stocks displaying solid earnings growth without considering their debt level does not seem to be 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 have a proven history of success.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 16 stocks that made it through the screen.
lululemon athletica (LULU - Free Report) : It is a yoga-inspired athletic apparel company that designs, manufactures and distributes athletic apparel and accessories. The company delivered average positive earnings surprise of 6.75% in the last four quarters and currently carries a Zacks Rank #2.
WellCare Health Plans : It provides government-sponsored managed medical care services. The company has a Zacks Rank of 2 and delivered average positive surprise of 17.32% in the trailing four quarters.
Omnicell (OMCL - Free Report) : It develops and markets end-to-end automation solutions for the medication-use process. The company came up with average four-quarter beat of 15.88% and holds a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
PC Connection (CNXN - Free Report) : It is a direct marketer of brand-name personal computers and related peripherals, software, and networking products. The stock is Zacks #1 Ranked stock and pulled off an average positive earnings surprise of 28.40% in the preceding four quarters.
Career Education Corporation : It is an educational services company and sports a Zacks Rank #1. Its average four-quarter positive earnings surprise is 23.89%.
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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.