Leverage refers to a well-known business strategy in corporate finance, which involves usage of borrowed capital by companies to ensure smooth run of operations and expansion of the same. Basically, it is the amount of debt a firm uses to invest in its business operations.
One may ask why a company chooses debt when the option of equity financing exists. The answer is simple. Debt is a much cheaper form of financing than equity. Moreover, payments on debt are tax deductible. So, the majority of companies resort to debt financing.
However, debt is still considered a taboo as it carries the burden of interest payments. In particular, companies with heavy debt loads are more vulnerable during economic downturns and can even go bankrupt if things go downhill.
So, if a company is highly leveraged, in other words carries an exorbitant amount of debt, investors will not be willing to add the stock. A high degree of financial leverage means high interest payments, which affects the bottom line.
Therefore, to avoid any kind of risky investment, choosing a less debt-ridden stock should be an appropriate option for a risk-averse investor. 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.
Investors are on the lookout for stocks that exhibited solid earnings growth in the last couple of quarters. However, blindly investing in stocks displaying solid earnings growth without considering their debt level is not a wise move.
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 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, Inc. 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 sports a Zacks Rank #1.
James River Group Holdings, Ltd. 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 4.72% in the last four quarters.
Clarus Corporation CLAR: This company engages in design, manufacture and marketing of outdoor equipment and apparel for climbing, mountaineering, backpacking, skiing and other outdoor recreation activities. It came up with average positive earnings surprise of 267.38% 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 Corp. BLD: It is an installer and distributor of insulation products to the construction industry primarily in the United States. Currently, the company sports a Zacks Rank #1. It came up with average positive earnings surprise of 8.8% in the preceding four quarters.
Aaron’s, Inc. AAN: This company is engaged in the sales and lease ownership and specialty retailing of residential and office furniture, consumer electronics, home appliances and accessories. It sports a Zacks Rank #1. It delivered average positive earnings surprise of 4.42% 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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TopBuild Corp. (BLD) : Free Stock Analysis Report
Aaron's, Inc. (AAN) : Free Stock Analysis Report
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Herman Miller, Inc. (MLHR) : Free Stock Analysis Report
Clarus Corporation (CLAR) : Free Stock Analysis Report
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