In the complex world of investment, debt financing is a well-known strategy adopted by the majority of corporations for expanding their business operations from time to time. Dearth of ample funds is the primary driving force behind this strategy. However, resorting to debt is still considered a taboo as it carries the burden of interest payments.
This is because companies with large debt loads are more vulnerable during economic downturns and can even go bankrupt in the worst case scenario. Of course, companies may resort to equity financing as an alternative option to boost their financial resources. 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.
So, debt financing remains the favored option for corporates in times of funding their operations. In particular, it is the easy and cheap availability of debt that makes it more popular among corporations.
However, too much debt is detrimental for a company’s health. If a company is highly leveraged, in other words carries exorbitant amount of debt, investors will not add it to their portfolios willingly. Afterall, a high degree of financial leverage means high interest payments, which may affect the company's bottom line.
With the current U.S. administration being in favor of a steady interest rate hike over the near term, investors might be reluctant to pick any U.S. stock for the time being. However, a mere rate hike should not discourage investors since the U.S. economy has been debt dependent since its foundation and is still the largest in the world. What they need to do is pick companies that have a lower debt burden.
This is where the significance of financial leverage ratio comes into play as it measures the extent of financial leverage a company bears. To choose a corporation that is not so highly indebted, several leverage ratios have been developed over the years, with debt-to-equity ratio being the most popular.
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 Q4 earnings season coming to an end, investors must be targeting companies with solid earnings growth projections. But, in the uncertain world of investment, markets can falter anytime, particularly affecting companies with a higher degree of financial leverage. Therefore, 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 wise to choose stocks with a low debt-to-equity ratio to ensure safe 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 (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 21 stocks that made it through the screen.
Merit Medical Systems Inc. MMSI: It provides various peripheral and cardiac intervention products to cure cardiac conditions specific to interventional cardiology and electrophysiology. The company delivered average positive earnings surprise of 7.36% in the last four quarters and currently carries a Zacks Rank #2.
Pinnacle West Capital Corporation PNW: It is involved in the generation, transmission and distribution of electricity from coal, nuclear, gas, oil and solar. The company currently holds a Zacks Rank of 2 and delivered average positive earnings surprise of 6.15% over the trailing four quarters.
Amedysis, Inc. AMED: It offers home health and hospice services throughout the United States to the growing chronic, co-morbid, and aging American population. The company came up with average positive earnings surprise of 16.55% in the preceding four quarters and sports a Zacks Rank #1 at present. You can see the complete list of today’s Zacks #1 Rank stocks here.
Southwest Airlines Co. LUV: It is a passenger airline that provides scheduled air transportation in the United States. Currently, the company carries a Zacks Rank #2. It came up with average positive earnings surprise of 3.27% in the preceding four quarters.
Royal Carribean Cruises Ltd. RCL: It is a cruise company that owns and operates three global brands — Royal Caribbean International, Celebrity Cruises and Azamara Club Cruises. It currently carries a Zacks Rank #2 and delivered average positive earnings surprise of 7.65% 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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Southwest Airlines Co. (LUV) : Free Stock Analysis Report
Pinnacle West Capital Corporation (PNW) : Free Stock Analysis Report
Royal Caribbean Cruises Ltd. (RCL) : Free Stock Analysis Report
Amedisys, Inc. (AMED) : Free Stock Analysis Report
Merit Medical Systems, Inc. (MMSI) : Free Stock Analysis Report
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