In corporate finance, leverage, otherwise termed as debt financing, is the use of exogenous funds by corporations to run their operations smoothly and expand the same. While there is option for equity financing, if a company wants to avoid debt, historically debt financing has been preferred over equity.
Such a choice is driven by the cheap and easy availability of debt compared with equity financing. However, one should keep in mind that debt financing remains 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 lead to a corporation’s bankruptcy in a worst case scenario.
This is because while debt brings with it the capacity to spend a little bit more, it also carries the burden of repayment with additional interest in the future. As a result, prudent investors try to avoid companies with large debt loads since they are more vulnerable during economic downturns.
Empirically it has been found that in periods of low interest rates, debt financing has gained more traction. At present, with robust parameters supporting growth across the U.S. economy and thereby favoring interest rate hike, the market is not very attractive for hugely burdened companies. Naturally, investors would like to avoid debt ridden stocks and seek those bearing low debt levels. Debt-free stocks are, however, rare.
Therefore, to safeguard one’s portfolio from losses, an investor should prudently determine whether the stock’s debt level is sustainable. Historically, several leverage ratios have been developed to measure the amount of debt a company bears and debt-to-equity ratio is one of the most common 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 indicates improved solvency for a company.
With the second quarter earnings season approaching, investors must be eyeing companies that exhibited solid earnings growth in the prior quarters. However, blindly pursuing high earnings yielding stocks might drain all your money before you know, especially if the stock bears a high debt-to-equity ratio.
Considering this, it will be wise for investors to select companies with low leverage. These are financially more secure and immune to financial bankruptcy.
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.
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 30 stocks that made it through the screen.
HollyFrontier Corp (NYSE:HFC): The company produces and markets gasoline, diesel, jet fuel, asphalt, heavy products and specialty lubricant products. It pulled off an average positive earnings surprise of 41.26% in the trailing four quarters and currently sports a Zacks Rank #1.
Amedisys Inc (NASDAQ:AMED): It provides home health and hospice services throughout the United States to the growing chronic, co-morbid and aging American population. The company sports a Zacks Rank #1 and delivered an average positive earnings surprise of 10.58% in the trailing four quarters.
MGM Growth Properties (NYSE:MGP): The company is one of the leading publicly traded real estate investment trusts engaged in the acquisition, ownership and leasing of large-scale destination entertainment and leisure resorts. It pulled off an average positive earnings surprise of 3.02% in the trailing four quarters and currently carries a Zacks Rank #2.
Brown & Brown (NYSE:BRO): It offers a broad range of insurance and reinsurance products and services, as well as risk management, third party administration, managed health care, and Medicare set-aside services and programs. The company has a Zacks Rank #2 and pulled off an average positive earnings surprise of 9.53% in the trailing four quarters.
Westlake Chemical (NYSE:WLK): It is a vertically integrated international manufacturer and supplier of petrochemicals, polymers and fabricated products. The company currently sports a Zacks Rank #1 and delivered an average positive earnings surprise of 5.86% 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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