In case you’re new in stock investing, learning the market jargon or lingo is important. Investors, traders, and analysts use a variety of terms to converse. But among the terms that send chills when evaluating a stock to buy is the proverbial red flag. The word points toward danger so as a market player, you should better beware.
What does a red flag mean?
A red flag is a threatening signal in the financial markets. When one waves the red flag, it’s demanding attention. Prior to any stock purchase, a stock market analyst will conduct a review of a company’s stock. The results will highlight, among others, the red flags that will have a potentially material impact on the stock investment.
If a would-be problem with a security is raised, caution is advised. But since red flags come in different types, investors also have differing views. Sometimes a particular red flag can affect the decision or pose no real threat at all. It all depends on the investor’s methodology or criteria in picking equity issues.
Some red flags you need to take note of when evaluating a stock
When a company decides to list on the stock market, everything about them is open to public scrutiny. Every move from changes in corporate structure to business activities needs to be disclosed.
Stock market watchdogs are also vigilant when it comes to regulatory compliance and violations. Unsound business practices and poor corporate governance can lead to blacklisting, if not complete delisting. As such, investors have access to all financial data and non-financial information.
When evaluating a stock, gather as much info and watch out for some red flags:
- Financial distress
Publicly traded companies compile and publish monthly, quarterly, and annual financial statements. It’s incumbent upon the chief financial officer, auditor or accountant to ensure all data contained in the financial reports are accurate. But red flags may not be obvious on a one-year financial record.
The rule of thumb is to review the latest three years financial statement to ascertain a company’s financial health. From the set of financial reports, declining revenues, inefficient funds utilization, weak cash flows, and aging receivables can be seen.
2. Huge debt levels
What could add to the company’s financial distress is the level of debt. As much as possible, avoid investing in companies that carry a huge amount of debt. Debt levels are usually industry-specific. Use financial metrics and compute the debt-to-equity ratio.
A company with a high ratio means the firm is highly leveraged and therefore a risky investment. As an example, a 2:1 ratio is sound because for every 2 shares there is 1 debt. Ideally, the debt should be less than 2 times the equity.
Further, when a company takes on more borrowing but does not actually add value to the business, then expect the debt-to-equity ratio to rise. Trouble is brewing if the company is unable to pay down its liabilities or debts on a regular and prompt basis.
3. Weak sales and high inventories
Declining revenues are borne out of weak sales and high inventories. If a company is experiencing poor sales growth, it could mean a branding image problem.
When products and services are not moving as anticipated, the situation would lead to rising account receivables and later on to severe liquidity problems. If this trend continues unabated, steer clear of the company.
4. Non-payment of dividends
For investors who prefer dividend stocks, be conscious of the company’s history of dividend payments. Companies that have been consistently paying dividends pose no problem. However, once there is cut or non-payment of dividends, there is a manifestation of financial instability.
Also, be wary of the so-called dividend trap. Some companies may promise higher dividend payments above the industry level. Not all stocks with high-dividend yields are necessarily attractive investments.
5. Changes in the management team and employee turn-over
Investors don’t want to see a revolving door where the changing of the top management team occurs every so often. It’s not a financial metric but a sign of management inefficiency.
Another red flag is the high incidence of employee turnover. It’s a key indicator that somehow tells about the manner by which the company takes care of its people. Company layoff is another telltale sign.
6. Scandals and controversies
A company with strong fundamentals but are entangled in scandals and controversy would suffer the loss of credibility and reputation. What will ensue is a sharp drop in the stock price and swift erosion of market value.
A business owner that buys back his company’s stock is comforting to stockholders. However, if the buyback is happening at a rapid pace, regardless of price, there might be a hidden agenda. The owner is either boosting earnings or engaging in heavy insider selling.
There are also disturbing signs that reek of fraud and dishonesty. Directors and senior officers might be unloading their stock holdings and vested options unceremoniously. Unreported related party transactions are ominous signs too.
Once unsound business practices are revealed to the public, expect a free fall. In some instances, the company may no longer rise from the negative publicity and declare bankruptcy.
Always pay close attention to red flags
Stock investing is not without risks. The examples given here are just some of the common red flags and not an exhaustive list. The way to avoid them is to practice due diligence. Now and again, fundamental analysis is necessary if you want to detect the danger signs.
At first, all publicly listed companies will appear as viable investments to the average investor. But the moment a comprehensive review is conducted, their weaknesses will come to light.
Red flags will, without a doubt, appear to serve as a warning. Should there be none, you know you’re making the right choice. Remember that a red flag is not just a term but a peril. Pay close attention to red flags before making a stock purchase.
Written by Jocelyn dela Dingco, ZUU Online
This is a guest post by ZUU Online, an Asian-based Finance Education Portal aimed at helping individuals to improve their knowledge on personal finance and money, through educational articles on business, investments, property and insurance.
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