In corporate finance, leverage is a well-known concept that refers to the practice of borrowing capital by companies to run their operations smoothly and expand the same. Notably, such borrowings can be made either through equity financing or debt financing.
Empirically, it has been observed that the majority of companies prefer debt financing over equity to obtain such funds. This is because debt is cheaper than equity, especially in periods of low interest rates. Moreover, in the case of equity financing, a shareholder not only becomes a company’s partial owner but also gets entitled to a direct claim on its future profits. So, most companies try to avoid equity financing.
However, debt financing has its own drawbacks. In particular, exorbitant debt financing can be damaging for a company’s financial position and can cause bankruptcy in the worst-case scenario. Therefore, the debt level of a company is an important point of consideration while making an investment decision.
If a stock is highly leveraged, which means it possesses considerably high debt, it is wise to avoid it.
Considering the aforementioned discussion, a low-leverage stock should find a place in an investor’s portfolio. For measuring this leverage, several ratios have been used historically. The debt-to-equity ratio is one of the most common among such ratios.
Analyzing Debt/Equity
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 the third-quarter earnings season knocking at our doors, investors must be eyeing stocks that exhibited solid earnings growth in the recent past. 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 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 25 stocks that made it through the screen.
ScanSource, Inc. SCSC : It serves North America as a value-added distributor of specialty technologies, including automatic identification and point-of-sale products, and business telephone products. The company delivered an earnings surprise of 27.90%, on average, in the trailing four quarters and sports a Zacks Rank #1 currently.
Jacobs Engineering Group Inc. J : It is one of the leading providers of professional, technical and, construction services to industrial, commercial and governmental clients. The company currently holds a Zacks Rank #2 and delivered an earnings surprise of 17.54% in the trailing four quarters, on average.
CBIZ, Inc . CBZ : It provides professional business services that help clients better manage their finances and employees. The company came up with a four-quarter earnings surprise of 43.44%, on average, and has a Zacks Rank of 2. You can see the complete list of today’s Zacks #1 Rank stocks here .
Primerica, Inc. PRI : It provides financial products and services. Currently, the company holds a Zacks Rank of 2. It came up with a four-quarter earnings surprise of 7.55%, on average.
AdvanSix Inc. ASIX : It is a producer and supplier of Nylon 6 materials. The company currently sports a Zacks Rank #1 and delivered a four-quarter earnings surprise of 50.74%, 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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