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 borrowing of funds for such purposes.
Now a company can borrow money either through debt financing or equity financing. Yet, historically, it has been witnessed that companies prefer debt financing over equity financing. This is because when a company resorts to debt financing, it takes on fixed expenses in the form of interest payments for a specific time period.
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. So, debt financing remains the preferred option for corporates.
It is imperative to mention that debt financing remains a feasible option as long as the companies succeed in generating a higher rate of return compared to the interest rate. Exorbitant debt financing might even lead to a corporation’s bankruptcy in the worst-case scenario.
Since a debt-free company is rare to find, we should focus on those carrying low debt levels. Historically, several leverage ratios have been developed to measure the amount of debt a company bears. Debt-to-equity ratio is one of the most common 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.
With the Q4 reporting cycle in full swing, investors must be looking for stocks that have a history of reporting solid results. 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.
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 17 stocks that made it through the screen.
Gibraltar Industries Inc. (ROCK - Free Report) : The company manufactures products ranging from ventilation and expanded metal to mail storage solutions and rain dispersion products and solutions. It delivered positive earnings surprise of 1.95% on average in the last four quarters and currently carries a Zacks Rank #2.
Bank of Montreal (BMO - Free Report) : It is one of the largest banks in North America, offering a complete range of financial services in its chosen markets on both sides of the Canada-United States border. The company carries a Zacks Rank #2 and delivered positive surprise 0.82% on average in the trailing four quarters.
Ralph Lauren Corporation (RL - Free Report) : It is a major designer, marketer and distributor of premium lifestyle products including apparel, footwear, accessories, home furnishings, and other licensed product categories. The company came up with average four-quarter beat of 11.28% and sports a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
Teradyne (TER - Free Report) : It a leading provider of automated test equipment, with a major focus on the semiconductor test market. The stock is Zacks #2 Ranked and pulled off average positive earnings surprise of 12.64% 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.