Leverage, in particular financial leverage, is a commonly used term in everyday business. It refers to the amount of corporate debt individual companies bear. At the macro level, it is the cumulative public debt that ultimately determines a nation’s fiscal deficit and thereby its economic fate.
Debt financing is nothing new in the world of investment and only a fortunate few can escape it. No one voluntarily wishes to be a part of a debt-ridden nation as after all debt means carrying the burden of interest payments. Still, most companies resort to debt financing instead of equity financing, probably because debt is more easily and cheaply available.
In fact, in the majority of matured economies, the debt market is larger than the equity market in terms of market capitalization. In this context, it is imperative to mention the debt situation of the U.S. Yes, America – the richest economy in the world is the biggest borrower too. In fact, a fresh estimate from the Congressional Budget Office projects the country’s debt this year to spike 35% to $590 billion, compared to last year.
However, this should not dissuade investors from investing in stocks as debt has been a part of the U.S. economy since its foundation and yet the country stands atop others. Investors nevertheless need to choose wisely and select companies bearing lesser amount of debt.
This is where the significance of financial leverage ratio comes into play. This ratio measures the extent of financial leverage a company bears. Several leverage ratios have been developed for this purpose, with debt-to-equity ratio being the most popular among them.
Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity
Debt-to-equity is a liquidity ratio that indicates the amount of financial risk a company bears. A higher debt-to-equity ratio indicates that the company uses more debt financing compared to equity financing, thereby investing in its stock could prove to be risky.
It is imperative that companies recording higher earnings growth will attract investors. But if they bear high leverage then they might not generate satisfactory returns. This is because at the time of economic downturns, debt ridden companies are more prone to become victims of a debt trap.
Choosing the Winning Strategy
Considering the above discussion, it is obvious that a sensible investor will go for stocks bearing low debt-to-equity ratios. However, choosing stocks based solely on one financial metric might not fetch the desired outcome.
To ensure the maximum possible return from this strategy, we have expanded our screening procedure to include some other criteria.
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 matterwhether market conditions are good or bad, stocks with a Zacks Rank #1 (Strong Buy) or 2 (Buy) have a proven history of success.
VGMScore 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 final 14 stocks that made it through the screen.
Omega Protein Corporation OME: This renowned producer of a custom line of omega-3 fish oil, protein-rich specialty fish meal and organic fish solubles currently sports a Zacks Rank #1. It witnessed a 25.7% improvement in its current year consensus estimate in the last 60 days.
Comfort Systems USA Inc. FIX: This company offers installation, repair and replacement services for the mechanical services industry and currently carries a Zacks Rank #2. The company witnessed a 3% rise in its current year consensus estimate in the last 30 days.
NTT DOCOMO, Inc. DCM: This Japanese company is a predominant mobile phone operator in the nation. The current year consensus estimate for DOCOMO was up 22.9% in the last 30 days. The company carries a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
BofI Holding, Inc. BOFI: This is a holding company for BofI Federal Bank that provides consumer and business banking products in the U.S. It carries a Zacks Rank #2 and witnessed an avaerage positive earnings surprise of 2.96% in the trailing four quarters.
Gentex Corp. GNTX: This manufacturer of automatic-dimming rearview mirrors and electronics carries a Zacks Rank #2 and recorded a positive earnings surprise of 3.45% in the last quarter.
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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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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 GENTEX CORP (GNTX): Free Stock Analysis Report BOFI HLDG INC (BOFI): Free Stock Analysis Report COMFORT SYSTEMS (FIX): Free Stock Analysis Report OMEGA PROTEIN (OME): Free Stock Analysis Report NTT DOCOMO -ADR (DCM): Free Stock Analysis Report To read this article on Zacks.com click here.