Leverage, otherwise termed as debt financing, refers to the use of exogenous funds by corporations to run their operations smoothly and expand the same. Although there is an option for equity financing, historically, debt financing has been preferred over equity because of its easy and cheap availability.
Another perk of debt financing is that the interest on debt is tax deductible.
However, debt financing has its own share of drawbacks. In particular, debt financing is not desirable if it fails to generate a higher rate of return than the interest rate. So, one should always avoid resorting to exorbitant debt financing, which might even lead to a corporation’s bankruptcy in the worst-case scenario.
Considering the current economic situation worldwide on account of the ongoing pandemic, most investors are skeptical about the stock market’s performance, at least over the near term. Evidently, Wall Street's main indexes suffered a mild fall on Mar 17, as U.S. bond yields spiked ahead of the Federal Reserve's policy statement, which could provide hints on whether the central bank would raise interest rates sooner than expected.
So, to avoid huge losses, a prudent investor will choose stocks that bear low leverage since a debt-free corporation is rare to find. Therefore, measuring the leverage level of a particular stock forms an integral part of the safe investment procedure.
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 depicts that it has improved solvency.
With the fourth-quarter reporting cycle almost nearing its end, investors might be eyeing stocks that have exhibited solid earnings growth in recent 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 the debt-to-equity ratio might not fetch the desired outcome. To choose stocks that have the potential of generating 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.
Eagle Materials EXP: It manufactures and distributes Cement, Concrete and Aggregates, Gypsum Wallboard, Recycled Paperboard, as well as Oil and Gas Proppants from more than 75 facilities across the United States. The company — which currently has a Zacks Rank #2 — delivered an earnings surprise of 28.4%, on average, in the trailing four quarters.
Quanex Building Product Corporation NX: It is a manufacturer of components like energy-efficient fenestration products, in addition to kitchen and bath cabinet components that are sold to Original Equipment Manufacturers in the building products industry. The company currently has a Zacks Rank #2 and delivered an earnings surprise of 652.9% in the trailing four quarters, on average.
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. The company came up with a four-quarter earnings surprise of 25.8%, on average, and holds a Zacks Rank of 2 at present. You can see the complete list of today’s Zacks #1 Rank stocks here.
Green Brick Partners, Inc. GRBK: It is involved in land acquisition and development, entitlements, design, construction, along with marketing and sale of residential projects. Currently, the company carries a Zacks Rank #2 and came up with a four-quarter earnings surprise of 25.9%, on average.
Primoris Services Corporation PRIM: It operates as one of the largest specialty contractors and infrastructure companies in the United States. It currently sports a Zacks Rank #1 and delivered a four-quarter earnings surprise of 19.7%, 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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Eagle Materials Inc (EXP) : Free Stock Analysis Report
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