Leverage, otherwise termed as debt financing, is the use of exogenous funds by corporations to run their operations smoothly and expand the same. Although there is option for equity financing, historically, debt financing has been preferred over equity because of its easy and cheap availability.
However, one should keep in mind 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 theworst-case scenario.
Given the ongoing economic turmoil prevalent across the globe, courtesy of the coronavirus pandemic, investors should know that uncertainty can hit the global equity market anytime and therefore it is better to take measures beforehand than repent later.
Particularly, they should be aware of leverage, or in other words, how much debt a company owns.
This is because the higher the degree of financial leverage, higher is the interest payment for the capital borrowed.
And here comes the importance of leverage ratios, which have been constructed to safeguard investors from becoming victims of debt trap. Debt-to-equity ratio is one such measure, perhaps the most popular one, to evaluate a company’s creditworthiness for potential equity investments.
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 Q2 earnings in front of 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.
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 24 stocks that made it through the screen.
Teekay Tankers (TNK - Free Report) : It provides international marine transportation of crude oil and owns a fleet of nine double-hull Aframax-class oil tankers. The company delivered average four-quarter positive earnings surprise of 17.98% and currently carries a Zacks Rank #2.
Tesla Inc. (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%.
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 came up with four-quarter average positive earnings surprise of 2.39% and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Nice Ltd (NICE - Free Report) : It offers enterprise software solutions. Currently, the company sports a Zacks Rank #1 and came up with average four-quarter positive earnings surprise of 2.78%.
West Pharmaceutical Services (WST - Free Report) : It operates as a global drug delivery technology company. It currently holds a Zacks Rank #2 and delivered average four-quarter positive earnings surprise of 17.99%.
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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.