In the world of business finance, leverage refers to an investment strategy that involves borrowing of funds to finance the expansion of the business, purchase of inventory and other assets as well as supporting other aspects of business operations. Now financial leverage is the amount of debt that exists in the capital structure of a company.
While there exists option for equity financing, historically, debt financing has achieved more popularity among corporations 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 of stock. In other words, the borrower has no claim in the company’s shares.
Yet, debt financing has got its own drawbacks. It tends to shoot up the company’s risk of bankruptcy. This is because companies with high debt loads are more vulnerable during economic downturns.
Nevertheless, this should not discourage one to invest in stocks. Instead, to be on the safe side, investors should measure the extent of financial leverage a company is bearing before putting their hard-earned money in its stock.
And here comes the importance of leverage ratios, which have been constructed historically 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 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 implies that it has a more or less financially stable business, thereby making it a better investment pick.
As we have reached almost the end of Q4, the growth picture seems to be improving compared to what we saw in the year-ago quarter. Naturally, investors are gearing up to pour money in stocks exhibiting solid earnings growth.
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 might not be 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 the 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.
Estimated One-Year EPS Growth F(1)/F(0) greater than 5: This shows earnings growth expectation.
Zacks Rank #1 (Strong Buy) or 2 (Buy): Irrespective of market conditions, stocks with a Zacks Rank #1 or 2 have a proven history of success.
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 or 2 offer the best upside potential.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 17 stocks that made it through the screen.
Norbord Inc. OSB: This corporation is a producer of wood-based panels. It pulled off an average positive earnings surprise of 0.28% in the trailing four quarters and carries a Zacks Rank #1.
Huntington Ingalls Industries, Inc. HII: The company designs, builds and maintains nuclear and non-nuclear ships for the U.S. Navy and Coast Guard and provides after-market services for military ships around the globe. It carries a Zacks Rank #2 and has delivered an average positive earnings surprise of 14.22% in the trailing four quarters.
Lam Research Corporation LRCX: It provides market-leading equipment and services for semiconductor wafer processing. It pulled off an average positive earnings surprise of 5.33% in the trailing four quarters and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
SK Telecom Co., Ltd. SKM: It is the provider of the world's first commercial CDMA digital cellular service. The company carries a Zacks Rank #2 and has a long-term earnings growth rate of 7.7%.
WellCare Health Plans, Inc. WCG: It provides managed care services for government-sponsored health care programs. The company sports a Zacks Rank #1 and has delivered an average positive earnings surprise of 64.34% in the trailing 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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Huntington Ingalls Industries, Inc. (HII) : Free Stock Analysis Report
Norbord Inc. (OSB) : Free Stock Analysis Report
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Lam Research Corporation (LRCX) : Free Stock Analysis Report
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