Companies often need exogenous funds to ensure smooth operations and expansion of business. These funds can be arranged through debt and equity. Here comes the concept of leverage, which is basically borrowing of funds for such purposes.
This borrowing can be done through equity or debt financing.
Now, the theory of cost reveals that most companies prefer debt financing over equity since debt is cheaper, especially in periods of low interest rates. This is because when a company resorts to debt financing, it takes on fixed expenses in the form of interest payments for a specific time period.
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.
Yet, debt is something that gives you the chills since it brings with it the burden of repayment with additional interest in the future.
Especially, in times of crisis like the ongoing one, 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, to safeguard one’s portfolio from notable losses, the real challenge for an investor is determining whether the organization’s debt level is sustainable. A debt-free corporation is rare to find. Historically several leverage ratios have been developed to measure the amount of debt a company bears and the 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 shows improved solvency for a company.
With the Q2 reporting cycle in full swing right now, investors may choose companies that are exhibiting 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 (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 21 stocks that made it through the screen.
Medpace Holdings (NASDAQ:MEDP) MEDP: It is a clinical contract research organization, which provides Phase I-IV clinical development services to the biotechnology, pharmaceutical and medical device industries. The company delivered an earnings surprise of 18.48%, on average, in the trailing four quarters and currently sports a Zacks Rank #1.
Lakeland Industries (NASDAQ:LAKE) LAKE: It is engaged in the manufacturing of protective clothing to help improve the quality of safety for the industrial workforce. The company currently sports aZacks Rank #1 and delivered an earnings surprise of 722.92% in the trailing four quarters, on average.
The Descartes (NASDAQ:DSGX) Systems Group DSGX: It is a provider of software-as-a-service logistics solutions. The company came up with a four-quarter earnings surprise of 6.94%, on average, and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Piedmont Office (NYSE:PDM) Realty Trust PDM: It is an integrated and self-managed real estate investment trust specializing in the acquisition, ownership, management and development of commercial real estate properties. Currently, the company carries aZacks Rank #2 and came up with a four-quarter earnings surprise of 0.06%, on average.
West Pharmaceutical Services (NYSE:WST) WST: It operates as a global drug delivery technology company. It currently sports a Zacks Rank #1 and delivered a four-quarter earnings surprise of 21.42%, 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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Piedmont Office Realty Trust, Inc. (PDM): Free Stock Analysis Report
West Pharmaceutical Services, Inc. (WST): Free Stock Analysis Report
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Medpace Holdings, Inc. (MEDP): Free Stock Analysis Report
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