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 the usage of debt for such purposes.
Empirically, it has been found that most companies prefer debt financing over equity to enhance their shareholder value. This is because debt is cheaper than equity, especially in periods of low interest rates.
However, in the complex world of investment, understanding the amount of financial leverage a company bears is crucial. This is because the higher the degree of financial leverage, higher is the interest payment for the capital borrowed.
In fact, exorbitant debt financing might even cause a corporation’s bankruptcy in the worst-case scenario.
Nevertheless, this should not dissuade companies from adopting debt financing as a strategy because after all debt comes cheaper when compared to equity. What a prudent investor needs to do is that to measure whether the debt level of a company is sustainable, 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 almost behind us, investors may intend to choose companies that have exhibited solid earnings growth. 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. : 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. VGM Score of A or B 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 20 stocks that made it through the screen.
Lakeland Industries ( LAKE Quick Quote LAKE - Free Report) : It designs and manufactures a wide variety of technologically advanced protective clothing for workers in a number of industries in which hazardous materials can be handled. The company delivered average four-quarter positive earnings surprise of 722.92% and currently sports a Zacks Rank #1. Tesla Inc. ( TSLA Quick Quote TSLA - Free Report) : It specializes in electric vehicle manufacturing. The company currently carries a Zacks Rank #2 and delivered four-quarter average positive earnings surprise of 482.08%. AngioDynamics ( ANGO Quick Quote ANGO - Free Report) : It designs, manufactures and sells a wide range of medical, surgical and diagnostic devices. The company came up with four-quarter average positive earnings surprise of 107.37% and carries a Zacks Rank #2. You can see . the complete list of today’s Zacks #1 Rank stocks here ChannelAdvisor ( ECOM Quick Quote ECOM - Free Report) : It offers cloud-based e-commerce solutions and services. Currently, the company sports a Zacks Rank #1 and came up with average four-quarter positive earnings surprise of 136.70%. West Pharmaceutical Services ( WST Quick Quote WST - Free Report) : It operates as a global drug delivery technology company. It currently sports a Zacks Rank #1 and delivered average four-quarter positive earnings surprise of 17.99%.
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Disclosure: Performance information for Zacks’ portfolios and strategies are available at: . https://www.zacks.com/performance