Leverage refers to an investment strategy adopted by corporations, wherein they use borrowed capital to boost their operations and amplify possible returns from risk capital. Now, this borrowing can be done through either debt or equity financing.
However, empirically, it has been found 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.
Considering this, the current market situation might seem to be a perfect time for investors to be cheerful, as economic downturn caused by the novel coronavirus outbreak has forced the Federal Reserve to drag down the nation’s interest rate to 0%.
Yet, debt financing has its share of drawbacks. The problem arises when the amount of debt a company bears becomes exorbitant. A high degree of financial leverage means high interest payments, which affect a company's bottom-line growth.
Therefore, to safeguard one’s portfolio from notable losses, the real challenge for an investor is determining whether an organization’s debt level is sustainable. A debt-free corporation is hard to find. 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 Q1 reports beginning to come in, investors must be eyeing companies that have exhibited solid earnings growth in the past couple of quarters. 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 33 stocks that made it through the screen.
NextEra Energy NEE: It is a public utility holding company engaged in the generation, transmission, distribution and sale of electric energy. The company delivered average positive earnings surprise of 2.83% in the last four quarters and currently carries a Zacks Rank #2.
AeroVironment AVAV: It is a leading manufacturer of Unmanned Aircraft Systems and tactical missile systems used for surveillance and reconnaissance. The company currently sports a Zacks Rank #1 (Strong Buy) and delivered average positive earnings surprise of 5.72% for the last four quarters.
Amedysis, Inc. AMED: It offers home health and hospice services throughout the United States to the growing chronic, co-morbid, and aging population. The company came up with average positive earnings surprise of 19.58% in the preceding four quarters and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Atmos Energy ATO: It is engaged in regulated natural gas distribution and storage business. Currently, the company carries a Zacks Rank #2 and came up with average positive earnings surprise of 1.91% in the preceding four quarters.
Chemed CHE: The company operates through two subsidiaries: VITAS Healthcare Corporation and Roto-Rooter. While VITAS is the nation's largest provider of end-of-life hospice care, Roto-Rooter is the nation's leading provider of plumbing. It currently sports a Zacks Rank #1 and delivered average positive earnings surprise of 3.36% 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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Amedisys, Inc. (AMED) : Free Stock Analysis Report
NextEra Energy, Inc. (NEE) : Free Stock Analysis Report
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Atmos Energy Corporation (ATO) : Free Stock Analysis Report
Chemed Corporation (CHE) : Free Stock Analysis Report
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