In the theory of corporate finance, leverage refers to the strategy of borrowed capital that companies need to run their operations smoothly. Most of the companies raise this capital either by issuing debt securities, better known as debt financing or by selling common stock, i.e. equity financing.
It is imperative to mention in this context that debt financing has earned more popularity over the years when compared to equity financing.
This is because, on availing debt financing, the company’s equity does not get diluted as a result of issuing more shares. In other words, the borrower has no claim in the company’s shares.
Another perk of debt financing is that the interest on debt is tax deductible.
However, debt financing is not always desirable. In fact, debt financing remains a feasible option only 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 the worst-case scenario.
Coming to the current global economic situation, we observe that the equity market is still topsy-turvy, thanks to the coronavirus pandemic. So, investors should be even more careful while choosing stocks in such times of crisis.
This gives investors all the more reasons to be acquainted with leverage.
Considering the aforementioned discussion, one can safely invest in a stock as long as it bears a low level of debt.
Historically several leverage ratios have been developed to measure the amount of debt a company bears and the 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.
With the start of the Q3 reporting cycle, investors must be eyeing stocks that exhibited solid earnings growth in the prior quarters. But if a stock bears a high debt-to-equity ratio, in times of economic downturns, its so-called booming earnings picture might turn into a nightmare.
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 (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 18 stocks that made it through the screen.
BlueLinx Holdings BXC: It is the largest distributor of building products in the United States. The company delivered an earnings surprise of 15.89%, on average, in the trailing four quarters and currently carries a Zacks Rank #2.
Arcosa ACA: It is a manufacturer of infrastructure-related products and services, which serves construction, energy and transportation markets. The company currently has a Zacks Rank #2 and delivered an earnings surprise of 36.89% in the trailing four quarters, on average.
Darling Ingredients DAR: It is a global developer and producer of sustainable natural ingredients from edible and inedible bio-nutrients, creating a wide range of ingredients and specialty solutions for customers in the pharmaceutical, food, pet food, feed, technical, fuel, bioenergy, and fertilizer industries. The company came up with a four-quarter earnings surprise of 9.98%, on average, and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
D.R. Horton DHI: It is one of the leading national homebuilders, primarily engaged in the construction and sale of single-family houses both in the entry-level and move-up markets. Currently, the company carries a Zacks Rank #2 and came up with a four-quarter earnings surprise of 16.78%, on average.
360 DigiTech QFIN: It is a data driven, technology empowered digital platform. It currently holds a Zacks Rank #2 and delivered a four-quarter earnings surprise of 140.28%, 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.
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Darling Ingredients Inc. (DAR) : Free Stock Analysis Report
BlueLinx Holdings Inc. (BXC) : Free Stock Analysis Report
D.R. Horton, Inc. (DHI) : Free Stock Analysis Report
Arcosa, Inc. (ACA) : Free Stock Analysis Report
360 DigiTech, Inc. Sponsored ADR (QFIN) : Free Stock Analysis Report
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