Companies often need exogenous funds to ensure smooth operations and expansion of business. These funds can be arranged through debt and equity. Here comes the concept of leverage, which is basically the usage of debt for such purposes.
In the complex world of investment, understanding the amount of financial leverage a company bears is crucial. This is because the higher the degree of financial leverage, higher is the interest payment for the capital borrowed.
Nevertheless, this should not dissuade companies from adopting debt financing as a strategy because after all debt comes cheaper when compared to equity. Still, debt is something that gives you the chills since it brings with it the burden of repayment with additional interest in the future.
Especially, in times of crisis, no one can be fully sure of how a company will perform the next day and on top of that those bearing large amount of debt are even more prone to bankruptcy. Therefore, the debt level of a company is an important point of consideration while making an investment decision.
Several leverage ratios have emerged 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.
Although companies displaying high earnings growth should be ideal investment choices, those among them with high leverage may not generate satisfactory returns. Since a greater cohort of investors is risk-averse by nature, it is reasonable to expect that they 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 (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 23 stocks that made it through the screen.
Johnson & Johnson (JNJ - Free Report) : The company focuses on the development, manufacturing and marketing of pharmaceutical, medical, and consumer related healthcare products. It delivered average positive earnings surprise of 4.27% 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 has a Zacks Rank of 2 and delivered average positive surprise 1.95% for 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.
MDU Resources Group (MDU - Free Report) : It is a utility natural gas distribution company. The stock is Zacks #2 Ranked and pulled off average positive earnings surprise of 2.79% 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.