BiggnightsSure Signs of a Failing Stock
March 4th 2011 22:05
Any number of indicators can signify that a stock is about to decline. And while I may not be a stock expert, I have been doing extremely well in my mock stock portfolio on Investopedia so that should give me enough credibility. Sticking to these three rules probably won't make you the next Warren Buffet, but everybody has to start somewhere.
1. High Debt/Equity Ratio
A company that is involved in too much debt as opposed to equity is always a risk. Relying on too much debt in financing can cause a stock to become volatile because of interest charges and how quickly the company can pay it back.
However, there are other factors that go into a high debt/equity ratio. If the company earns returns at a higher rate than they pay interest on debt, then this indicator may not be so bad after all. The debt ratio (total debt/total assets) is an additional measurement that can be used to assess risk.
2. Negative Cash Flows
The cash flow statement is usually broken down into three categories: operating, investing, and financing. Essentially, the operating cash flows are the day-to-day activities of the company, the investing cash flows are typically loans or mergers (anything that involves the company making a long term investment), and the financing cash flows come from investors in the company.
In order to pay off its debts, a company needs to have cash flows. Many investors simply look at the bottom line and completely ignore one of the more telling signs of current financial health, its cash flows. After all, a company can have a high net income, but they may still be buried in negative cash flows and debt. That would be a sure indicator that the stock of this company is destined to fall.
3. Miscellaneous Reasons
I know most of you are thinking that I put this vague all-encompassing "rule" in here just so that I could say I was right in literally any scenario, but that is only partly true. When I refer to miscellaneous reasons, I really only mean a few specific financial "red flags" that can drive down the stock price of a company.
Any publicly available information that is likely to lead to more sellers than buyers is a "red flag." Examples include government regulations, SEC investigations, insider trading, a change in high ranking personnel, and other public controversies.
These three rules are not always enough of an indicator by themselves. However, if a company falls into two or three of the categories, then you can expect a sharp decrease in stock price regardless of what other valuations such as the discounted cash flow method may predict. Of course, every rule has an exception, so it is really up to the individual investor to know what they are getting themselves into.
This leads me to my final point, which is that before you invest, always do your research. Or just pay someone to do it for you.
* images on this page were taken from the following Wikipedia pages:
Wall Street
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