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. Financial leverage is the amount of debt that exists in the capital structure of a company.
Per the theory of cost of capital, a company’s capital structure reflects a mix of debt and equity used to finance its capital projects. 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. Consequently, debt financing has emerged as a more popular financing option among the majority of corporations.
But debt financing has its share of drawbacks. The problem arises when leverage becomes exorbitant. A high degree of financial leverage means high interest payments, which tend to affect the company’s bottom line.
Of course, this does not mean that debt financing should be a taboo in corporate financing. Nevertheless, given the current macroeconomic scenario in the United States, in favor of interest rate hikes, the market seems to be not so suitable for borrowers
Therefore, to safeguard their portfolio from losses, the real challenge for an investor is to determine whether the organization’s debt level is sustainable. This is because a debt-free corporation is rare 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 indicates improved solvency for a company.
With the first-quarter reporting in its last lap, investors must be targeting stocks that are exhibiting solid earnings growth. But if the stocks bear a high debt-to-equity ratio, in times of economic downturns, their so-called booming earnings picture might turn into a nightmare.
Considering this, it will be wise for investors to select companies with low leverage. These are financially more secure and immune to financial bankruptcy.
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.
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 23 stocks that made it through the screen.
Louisiana-Pacific Corporation (NYSE:LPX): The company manufactures building materials and engineered wood products in the United States, Canada, Chile and Brazil. It pulled off an average positive earnings surprise of 0.75% in the trailing four quarters and currently sports a Zacks Rank #1.
Amedisys Inc (NASDAQ:AMED): It provides home health and hospice services throughout the United States to the growing chronic, co-morbid and aging American population. The company carries a Zacks Rank #2 and delivered an average positive earnings surprise of 10.58% in the trailing four quarters.
MGM Growth Properties LLC (NYSE:MGP): The company is one of the leading publicly traded real estate investment trusts engaged in the acquisition, ownership and leasing of large-scale destination entertainment and leisure resorts. It pulled off an average positive earnings surprise of 3.02% in the trailing four quarters and currently carries a Zacks Rank #2.
Oshkosh Corp (NYSE:OSK): It is a leading manufacturer and marketer of access equipment, specialty vehicles and truck bodies for the primary markets of defense, concrete placement, refuse hauling, access equipment and fire & emergency. The company carries a Zacks Rank #1 and pulled off an average positive earnings surprise of 42.24% in the trailing four quarters.
Federated National Holding Co (NASDAQ:FNHC): It is an insurance holding company, which, through its subsidiaries, controls all aspects of the insurance underwriting, distribution and claims processes. The company currently sports a Zacks Rank #1 and delivered an average positive earnings surprise of 23.03% 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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