Leverage is a well-known business strategy to use borrowed funds for financing the purchase of inventory, equipment and other company assets. These funds can also be utilized to repay the company’s prior debt. Companies can obtain such funds either using debt or equity.
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 projects federal debt to rise to 92% of the economy’s GDP in 2029 from 78% in 2019.
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 load.
Therefore, the debt level of a company is an important point of consideration while making an investment decision.
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 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 Q4 reporting cycle coming up, an investor must be looking for stocks that performed well in earlier quarters. However, companies displaying high earnings growth along with high leverage ratios are not the ideal investment choices. So, investors should select 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 24 stocks that made it through the screen.
Oasis Midstream Partners (OMP - Free Report) : The partnership owns, develops, operates and acquires a diversified portfolio of midstream assets primarily in North America. It delivered positive earnings surprise of 4.29% on average in the last four quarters and currently carries a Zacks Rank #2.
Amedisys (AMED - Free Report) : It provides home health and hospice services throughout the United States to the growing chronic, co-morbid, and aging American population.. The company sports a Zacks Rank #1 and delivered positive surprise 21.08% on average 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.
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.
Chemed Corp. (CHE - Free Report) : It is engaged in diverse business activities including provision of end-of-life hospice care along with plumbing and drain cleaning services. The company carries a Zacks Rank #2, while its four-quarter positive earnings surprise is 3.43%, on average.
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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.