In corporate finance, leverage is a popular investment strategy that involves borrowing of funds to expand business, purchase inventory and other assets as well as support different aspects of business operations. This borrowing can be through equity or debt financing.
Now, the theory of cost 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, resorting to debt is still considered a taboo as it carries the burden of interest payments. In particular, 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 a company's bottom line.
This is because companies with heavy debt load are more vulnerable during economic downturns and can even go bankrupt if things go downhill.
Since existence of a debt-free company is rare, to safeguard their portfolio from notable losses, the real challenge for an investor is determining whether an organization’s debt level is sustainable. To gauge how risky a company is, potential equity investors look at leverage ratios. 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 full swing, investors must be eyeing companies that have exhibited solid earnings growth in the past couple of quarters. However, blindly pursuing high earnings yield 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 22 stocks that made it through the screen.
Herman Miller MLHR: The company is a major American manufacturer of office furniture, equipment and home furnishings. It delivered average positive earnings surprise of 7.02% in the last four quarters and currently carries a Zacks Rank #2.
James River Group Holdings JRVR: It is an insurance company, which owns and operates specialty insurance and reinsurance companies. The company currently holds a Zacks Rank of 2 and delivered average positive earnings surprise of 2.62% in the last four quarters.
Chemed CHE: This company is the largest provider of end-of-life hospice care services through its VITAS Healthcare Corporation subsidiary in the United States. It came up with average positive earnings surprise of 4.81% 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.
TopBuild BLD: It is an installer and distributor of insulation products and serves the construction industry, primarily in the United States. Currently, the company holds a Zacks Rank #2. It came up with average positive earnings surprise of 8.80% in the preceding four quarters.
Oasis Midstream Partners LP OMP: This company owns, develops, operates and acquires a diversified portfolio of midstream assets primarily in North America. It sports a Zacks Rank #1. It delivered average positive earnings surprise of 0.27% in the last four quarters.
Get the rest of the stocks on the list and start putting this and other ideas to the test. It can all be done with the Research Wizard stock picking and back testing software.
The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.
Click here to sign up for a free trial to the Research Wizard today.
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.
Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report
TopBuild Corp. (BLD) : Free Stock Analysis Report
James River Group Holdings, Ltd. (JRVR) : Free Stock Analysis Report
Chemed Corporation (CHE) : Free Stock Analysis Report
Herman Miller, Inc. (MLHR) : Free Stock Analysis Report
Oasis Midstream Partners LP (OMP) : Free Stock Analysis Report
To read this article on Zacks.com click here.
Zacks Investment Research