In corporate finance, leverage is a well-known business strategy adopted by companies to borrow funds to finance working capital requirements, acquisitions or for some kind of business expansion. Now, the two most common financial resources corporates resort to are debt and equity.
Interestingly, a comparative analysis of the cost of capital theory reveals that most companies prefer debt financing over equity, as debt is available at a lower cost compared to equity; especially in periods of low interest rates. This happens because when a company finances its operations with debt, it takes on fixed expenses in the form of interest payments for a fixed time period.
Whereas, 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. Another perk of debt financing is that the interest on debt is tax deductible.
Yet, debt financing has its drawbacks. The problem arises when the amount of debt a company bears becomes exorbitant. Especially, at times of high interest rates, companies with large debt loads become more prone to bankruptcy.
That said, for the investor, the real challenge is determining whether the stock in which he/she is investing has a sustainable debt level, since a debt-free corporation is rare to find.
Therefore, the debt level of a company is an important point of consideration while making an investment decision. Several leverage ratios have emerged as efficient tools to evaluate a company’s credit level to support prudent equity investments. The most popular among them is the debt-to-equity ratio.
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 implies that it has a more or less financially stable business, thereby making it a better investment pick.
With the Q4 reporting cycle in full swing by now, companies reflecting high earnings growth should be ideal investment choices. However, such growth stocks may also be highly leveraged ones.
Since a greater cohort of investors is risk-averse by nature, it is reasonable to expect that they will be more attracted to companies with low leverage than high earnings growth.
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.
Estimated One-Year EPS Growth F(1)/F(0) greater than 5: This shows earnings growth expectation.
Zacks Rank #1 (Strong Buy) or 2 (Buy): Irrespective of market conditions, stocks with a Zacks Rank #1 or 2 have a proven history of success.
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 or 2 offer the best upside potential.
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.
Anthem, Inc. ANTM: The company is one of the largest publicly traded managed care organizations in terms of membership. It pulled off an average positive earnings surprise of 11.48% in the trailing four quarters and carries a Zacks Rank #2.
Jacobs Engineering Group Inc. JEC: The company is one of the world's largest and most diverse providers of technical, professional, and construction services, including all aspects of architecture, engineering and construction, operations and maintenance, as well as scientific and specialty consulting. It carries a Zacks Rank #2 and has delivered an average positive earnings surprise of 9.65% in the trailing four quarters.
BMC Stock Holdings, Inc. BMCH: It provides diversified building products and services to professional builders and contractors primarily in the residential housing market. It pulled off a positive earnings surprise of 3.03% in the last reported quarter and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Universal Health Services, Inc. UHS: It is one of the nation's largest and most respected healthcare management companies. The company carries a Zacks Rank #2 and boasts a solid long-term earnings growth rate of 6%.
Landstar System, Inc. LSTR: This company delivers safe, specialized transportation services to a broad range of customers, utilizing a network of agents, third-party capacity owners and employees. It carries a Zacks Rank #2 and has delivered an average positive earnings surprise of 4.97% in the trailing four quarters.
Get the rest of the stocks on the list and start putting this and other ideas to the test. It can all be done with the Research Wizard stock picking and back testing software.
The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.
Click here to sign up for a free trial to the Research Wizard today.
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.
Zacks Restaurant Recommendations: In addition to dining at these special places, you can feast on their stock shares. A Zacks Special Report spotlights 5 recent IPOs to watch plus 2 stocks that offer immediate promise in a booming sector. Download it free »
Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report
Landstar System, Inc. (LSTR) : Free Stock Analysis Report
BMC Stock Holdings, Inc. (BMCH) : Free Stock Analysis Report
Jacobs Engineering Group Inc. (JEC) : Free Stock Analysis Report
Anthem, Inc. (ANTM) : Free Stock Analysis Report
Universal Health Services, Inc. (UHS) : Free Stock Analysis Report
To read this article on Zacks.com click here.
Zacks Investment Research