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 acompany’s prior debt. Companies can obtain such funds either using debt or equity.
Historically, debt financing has been preferred 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 entitled to a direct claim to its future profits.
Now, the current market situation might seem to be a perfect time for investors to be cheerful, as economic downturn caused by the novel coronavirus outbreak has forced the Federal Reserve to lower the nation’s interest rate to 0%.
Yet, debt financing has its share of drawbacks. 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 a worst-case scenario.
A high degree of financial leverage means heavy interest payments, which affect a company's bottom line.
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.
With Q1 earnings in full swing, investors must be eyeing companies that have exhibited solid earnings growth in the past couple of quarters.
However, blindly pursuing high earnings yielding stocks, which have a high debt-to-equity ratio, might drain all your money before you know.
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 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 or 2 have a proven history of success.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 19 stocks that made it through the screen.
NextEra Energy (NEE - Free Report) : It is a public utility holding company engaged in the generation, transmission, distribution and sale of electric energy. The company delivered average positive earnings surprise of 2.39% in the last four quarters and currently carries a Zacks Rank #2.
Franco-Nevada Corporation (FNV - Free Report) : It operates as a gold-focused royalty and stream company with additional interests in silver, platinum group metals ("PGM"), oil & gas and other resource assets. The company currently carries a Zacks Rank #2 and delivered average positive earnings surprise of 18.77% for the last four quarters.
Amedysis, Inc. (AMED - Free Report) : It offers home health and hospice services throughout the United States to the growing chronic, co-morbid, and aging population. The company came up with average positive earnings surprise of 19.58% in the preceding four quarters and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Atmos Energy (ATO - Free Report) : It is engaged in regulated natural gas distribution and storage business. Currently, the company carries a Zacks Rank #1 and came up with average positive earnings surprise of 1.91% in the preceding four quarters.
Costco Wholesale Corporation (COST - Free Report) : The company sells high volumes of food and general merchandise (including household products and appliances) at discounted prices through membership warehouses. It currently has a Zacks Rank #2 and delivered average positive earnings surprise of 3.10% in the last four quarters.
Get the rest of the stocks on the list and start putting this and other ideas to the test. It can all be done with the Research Wizard stock picking and back testing software.
The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.
Click here to sign up for a free trial to the Research Wizard today.
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.