In corporate finance, companies frequently resort to a well-known strategy called leverage, which is the use of borrowed capital in their business operations. A company can borrow either through equity or debt financing.
Empirically, it has been found that most companies prefer debt financing over equity to enhance their shareholder value. This is because debt is cheaper than equity, especially in periods of low interest rates. To this end, it is imperative to mention that the current market situation seems favorable for corporates to take debt since the COVID-19 pandemic has forced the Federal Reserve to lower interest rate to a near-zero level.
Moreover,in case of equity financing, a shareholder not only becomes a company’s partial owner but also gets entitled to a direct claim to its future profits.
Yet, debt financing has its share of drawbacks. Particularly, one should keep in mind that debt financing is a feasible option as long as the companies succeed in generating a higher rate of return compared to the interest rate. Exorbitant debt financing might even cause a corporation’s bankruptcy in a worst-case scenario.
Especially, in times of crisis, no one can be fully sure of how a company will perform. On top of that those bearing large amount of debt are even more prone to bankruptcy. 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 shows improved solvency for a company.
With Q1 earnings almost over, investors may intend to choose companies that have exhibited solid earnings growth. However, blindly pursuing high earnings yielding stocks, which have a high debt-to-equity ratio, might drain all your money before you know.
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 or 2 have a proven history of success.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 20 stocks that made it through the screen.
Synopsys SNPS: It is a vendor of electronic design automation (EDA) software to the semiconductor and electronics industries. The company delivered average four-quarter positive earnings surprise of 10.51% and currently carries a Zacks Rank #2.
Tesla Inc. TSLA: It specializes in electric vehicle manufacturing. The company currently carries a Zacks Rank #2 and delivered four-quarter average positive earnings surprise of 482.08%.
Chemed Corp. CHE: It is engaged in diverse business activities including provision of end-of-life hospice care along with plumbing and drain cleaning services. The company came up with four-quarter average positive earnings surprise of 4.42% and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Teekay Tankers Ltd. TNK: This Marshall Islands corporationwas recently formed by Teekay Corporation to provide international marine transportation of crude oil. Currently, the company carries a Zacks Rank #2 and came up with average four-quarter positive earnings surprise of 17.98%.
West Pharmaceutical Services WST: It operates as a global drug delivery technology company. It currently sports a Zacks Rank #1 and delivered average four-quarter positive earnings surprise of 17.99%.
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.
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
Synopsys, Inc. (SNPS) : Free Stock Analysis Report
Tesla, Inc. (TSLA) : Free Stock Analysis Report
West Pharmaceutical Services, Inc. (WST) : Free Stock Analysis Report
Teekay Tankers Ltd. (TNK) : Free Stock Analysis Report
Chemed Corporation (CHE) : Free Stock Analysis Report
To read this article on Zacks.com click here.
Zacks Investment Research