“When you buy anything with lots of leverage, it does not require a whole lot to go wrong to lose it all.” – Barry Ritholtz

Indeed, in the complex world of investment, understanding the amount of financial leverage a company bears is crucial. Of course, many companies opt for debt financing to pursue their business operations and as long as they generate a higher rate of return compared to the interest rate they have to eke out, there’s no worry for shareholders. However, exorbitant debt financing might even lead to bankruptcy.

Over time, varied benchmarks based on leverage ratio have emerged as an efficient tool to evaluate a company’s credit worthiness, for potential equity investments. The most popular among them is the debt-to-equity ratio.

This metric is basically a liquidity ratio that indicates the amount of financial risk a company faces. A higher debt-to-equity ratio indicates that the company uses more debt financing compared to investor financing.

Analyzing the Formula

Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity

A lower debt-to-equity ratio implies a more financially stable business.

With the first quarter earnings season already on the go, investors must be eyeing companies with solid earnings growth. However, blindly pursuing high earnings yielding stocks might drain all your money before you know, if the stock bears a high debt-to-equity ratio.

This is because a high debt-to-equity ratio indicates a huge level of repayment that the company has to make in connection with the large debt amount, which had once exploded its earnings. This in reality makes the company’s so-called solid earnings a very volatile one.

The Winning Strategy

It goes without saying that given the current volatile market condition, which is already making investors more skeptical each day, choosing low leverage stocks will be a wise strategy.

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.

Here is the final screen:

Debt/Equity less than X-Industry Median: Thestocks are less leveraged compared to their industry peers. 

Current Price greater than or equal to 5: The stocks must be trading at a minimum of $5 or above.

Average 20-day Volume greater than or equal to 50000: Asubstantial trading volume ensures that the stock is easily tradable.

Percentage Change in EPS F(0)/F(-1) greater than X-Industry Median:Earnings growth add to the optimism, leading to stocks 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): Whether good market conditions or bad, stocks with a Zacks Rank #1 (Strong Buy) or #2 (Buy) 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. 

Although 37 stocks passed the screen, we have eliminated those which came with a negative or a zero debt-to-equity ratio.

Here are 5 stocks from the remaining 17 with a favorable debt-to-equity ratio:

• Columbia Sportswear Company (COLM - Analyst Report)
• World Wrestling Entertainment Inc. (WWE - Analyst Report)
• Tech Data Corp. (TECD - Analyst Report)
• Darden Restaurants, Inc. (DRI - Analyst Report)
• Koninklijke Ahold N.V. (AHONY - Snapshot Report)