Per the theory of cost of capital, a company’s capital structure reflects a mix of debt and equity that is used to finance its capital projects. Now a comparative analysis of the same theory reveals that most companies prefer debt financing over equity since debt is cheaper, especially in periods of low interest rates.
This is because when a company resorts to debt financing, it takes on 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 partial owner of the company but develops a direct claim on the company’s future profits as well. So, debt financing remains more dearer for corporates.
In fact, statistics indicate that America, the richest economy in the world, is the biggest borrower too. Notably, huge spending on wars, big tax cuts and stimulating economic programs have all added to the nation’s burden over the years. According to the latest estimates given by the Congressional Budget Office, federal debt is projected to increase to nearly 100% of the economy’s GDP by 2028.
Yet, debt financing has its share of drawbacks. The problem arises when leverage, referred to as the amount of debt a company bears, becomes exorbitant. A high degree of financial leverage means high interest payments, which affect the company's bottom line.
Nevertheless, this should not discourage investors from spending on U.S. stocks since debt has been part of the economy since its foundation and yet the country is a leader. What investors need to do is choose stocks with caution, thus avoiding those that carry high debt loads.
Empirically, several leverage ratios have been constructed to measure the exact amount of debt risk a company bears in order to safeguard investors from debt traps.
Debt-to-equity ratio is one such measure, perhaps the most popular one, which has been used to evaluate a company's credit worthiness, 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 indicates improved solvency for a company.
With the Q4 earnings season in full swing currently, investors must be targeting companies with solid earnings growth projections. But, in the uncertain world of investment, markets can falter anytime, particularly affecting companies with a higher degree of financial leverage. Therefore, blindly investing in stocks displaying solid earnings growth without considering their debt level is not a wise move.
The Winning Strategy
Considering the aforementioned factors, it is wise to choose stocks with a low debt-to-equity ratio to ensure safe 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 24 stocks that made it through the screen.
Merit Medical Systems Inc. MMSI: It provides various peripheral and cardiac intervention products to cure cardiac conditions specific to interventional cardiology and electrophysiology. The company delivered average positive earnings surprise of 7.36% in the last four quarters and currently carries a Zacks Rank #2.
Pinnacle West Capital Corporation PNW: It is involved in the generation, transmission and distribution of electricity from coal, nuclear, gas, oil and solar. The company currently holds a Zacks Rank of 2 and delivered average positive earnings surprise of 6.15% over the trailing four quarters.
Steelcase Inc. SCS: It offers a range of architecture, furniture and technology products and services designed to create high-performance work environments. The company came up with average positive earnings surprise of 21.87% in the preceding four quarters and sports a Zacks Rank #1 at present. You can see the complete list of today’s Zacks #1 Rank stocks here.
Southwest Airlines Co. LUV: It is a passenger airline that provides scheduled air transportation in the United States. Currently, the company carries a Zacks Rank #2. It came up with average positive earnings surprise of 3.27% in the preceding four quarters.
EMCOR Group, Inc. EME: The company is one of the leading providers of mechanical and electrical construction, industrial and energy infrastructure, and building services for a diverse range of businesses. It currently carries a Zacks Rank #2 and delivered average positive earnings surprise of 19.12% in the last four quarters.
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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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