Leverage, better to say financial leverage, indicates the degree to which a company utilizes debt to boost its operations and thereby earn escalated profit margins. However, the higher the degree of financial leverage, higher is the interest payment for the capital borrowed.
Nevertheless, this should not dissuade companies from adopting debt financing as a strategy, because after all debt comes cheaper when compared to equity. Still, debt is something that gives you the chills since it brings with it the burden of repayment with additional interest in the future.
In corporate finance, as long as companies successfully generate higher returns than the interest they need to pay, they remain safe havens for investors. But the problem arises when the level of debt a company bears exceeds the return it offers.
Especially, in times of crisis no one can be fully sure of how a company will perform the next day, and 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 a 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 more worthy investment opportunity.
Although companies reflecting high earnings growth should be ideal investment choices, those among them with high leverage may not generate satisfactory returns. 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
In theory, the optimal capital structure for a company is one that offers the ideal debt-to-equity ratio that maximizes its value and minimizes its cost of capital. Since, in practice, screening stocks based on these criteria is a bit difficult, herein, we choose low leverage stocks as these are considered safe bets.
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 criteria, as discussed below.
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): No matter whether market conditions are good or bad, 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 17 stocks that made it through the screen.
ePlus inc. (NASDAQ:PLUS): It is an engineering-centric technology solutions provider that offers information technology (IT) products and services, flexible leasing and financing solutions, and enterprise supply management in the United States. The company carries a Zacks Rank #2 and came up with an average positive earnings surprise of 20.08% in the trailing four quarters.
Teradyne, Inc. (NYSE:TER): This company is a manufacturer of automatic test equipment and related software for the electronics and communications industries. It carries a Zacks Rank #2 and delivered an average positive earnings surprise of 23.76% in the trailing four quarters.
EMCOR Group, Inc. (NYSE:EME): This corporation is engaged in design, integration, installation, start-up, testing, operation and maintenance of complex mechanical and electrical systems. It pulled off an average positive earnings surprise of 11.69% in the trailing four quarters and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Park Sterling Corp (NASDAQ:PSTB): It is engaged in providing banking products and services. The company carries a Zacks Rank #2 and came up with an average positive earnings surprise of 7.28% in the trailing four quarters.
Deutsche Post AG (OTCMKTS:DPSGY): It provides logistics services primarily in Germany, Europe, America, Asia Pacific and Other regions. The company carries a Zacks Rank #2 and delivered an average positive earnings surprise of 9.55% in the trailing 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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