In finance, leverage refers to an investment strategy of using borrowed money by corporates. Now this borrowing can be done through debt or equity financing. Empirically, firms prefer debt financing over equity.
This is because when a company resorts to debt financing, it incurs 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 company’s partial owner but also gets a direct claim to its future profits.
Yet, higher debt financing is never desirable. Particularly, one should keep in mind that debt financing is 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 cause a corporation’s bankruptcy in the worst-case scenario.
This is because a high degree of financial leverage means heavy interest payments, which affect a company's bottom line.
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.
Currently, massive sell-offs are going on across global equity markets as investors remain skeptical amid the novel coronavirus outbreak that has created a worldwide demand-supply disruption. Nevertheless, this should not discourage investors to spend in the stock market altogether. Instead, their investments should include stocks that are not highly leveraged.
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 12 stocks that made it through the screen.
West Pharmaceutical Services (WST - Free Report) : It is a global drug delivery technology company. The company delivered positive earnings surprise of 15.22% on average in the last four quarters and currently carries a Zacks Rank #2.
Principal Finance Group (PFG - Free Report) : It is a leading company in global investment management. The company carries a Zacks Rank #2 and delivered positive surprise 0.29% on average in the trailing four quarters.
Costco Wholesale (COST - Free Report) : It sells high volumes of foods and general merchandise (including household products and appliances) at discounted prices through membership warehouses. The company came up with average four-quarter beat of 3.10% and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Deckers Outdoor (DECK - Free Report) : It is a designer and producer of innovative, niche footwear and accessories developed for outdoor sports, and other lifestyle-related activities. The stock is Zacks #2 Ranked and pulled off average positive earnings surprise of 204.35% in the preceding four quarters.
WNS Holdings (WNS - Free Report) : It is engaged in business process outsourcing. The company has a Zacks Rank #2, while its four-quarter positive earnings surprise is 12.10%, 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.