In corporate finance, leverage is the use of exogenous funds by corporations to run their operations smoothly and expand the same. Although companies have the option of choosing between debt and equity financing, historically debt financing has been preferred.
This is because, 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.
However, it is imperative to mention that exorbitant debt financing is never desirable, since 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.
Since a debt-free company is rare to find, measuring the debt level of a company is an important point of consideration while making an investment decision. Historically, several leverage ratios have been developed to compute 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.
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 13 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.
JetBlue Airways (JBLU - Free Report) : It is a passenger airline company. The company carries a Zacks Rank #2 and delivered positive surprise 12.93% on average in the trailing four quarters.
BMC Stock Holdings (BMCH - Free Report) : It provides diversified building products and services to professional builders and contractors primarily in the residential housing market. The company came up with average four-quarter beat of 29.31% and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
AAR Corp. (AIR - Free Report) : It is an independent provider of aviation services to commercial and government customers worldwide. The stock is Zacks #2 Ranked and pulled off average positive earnings surprise of 8.07% 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 sports a Zacks Rank #1, while its four-quarter positive earnings surprise is 3.36%, 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.