Are Your Stocks Doomed?
Few people seem to spot the early signs of a company in distress. Remember WorldCom and Enron? Not so long ago, these companies were worth hundreds of billions of dollars. Today, they no longer exist. Their collapses came as a surprise to most of the world, including their investors. Even large shareholders, many of them with an inside track, were caught off guard. So is there any way to know that your stock may be on a crash course to nowhere? The answer is yes. Read on to find out how. (For more, see The 7 Biggest Stock Scams Of All Time.)
1. Negative Cash Flows
Cash flow is a company's lifeline; investors who keep an eye on it can protect themselves from ending up with a worthless share certificate. When a company's cash payments exceed its cash receipts, the company's cash flow is negative. If this occurs over a sustained period, it's a sign that the company's cash in the bank may be getting dangerously low. Without fresh injections of capital from shareholders or lenders, a company in this situation can quickly find itself insolvent. (For more insight, see The Essentials Of Cash Flow.)
2. High Debt-Equity Ratio
Interest repayments place pressure on cash flow, and this pressure is likely to be exacerbated for distressed companies. Because they have a higher risk of default, struggling companies must pay a higher interest rate to borrow money. As a result, debt tends to shrink their returns. The total debt-to-equity (D/E) ratio is a useful measure of bankruptcy risk. It compares a company's combined long- and short-term debt to shareholders' equity or book value. Companies with D/E ratios of 0.5 and above deserve a closer look.
3. Interest Coverage Ratio
The debt/equity (D/E) ratio doesn't always say much on its own. It should be accompanied by an examination of the debt interest coverage ratio. For example, suppose that a company has a D/E ratio of 0.75, which signals a low bankruptcy risk, but that it also has an interest coverage ratio of 0.5. An interest coverage ratio below 1 means that the company is not able to meet all of its debt obligations with the period's earnings before interest and tax (operating income). It's also a sign that a company is having difficulty meeting its debt obligations. (For more, read Looking At Interest Coverage.)
4. Share Price Decline
Savvy investor should also watch out for unusual share price declines. Almost all corporate collapses are preceded by a sustained share price decline. Enron's share price started falling 16 months before it went bust. That said, while a big share price decline might signal trouble ahead, it may also signal a valuable opportunity to buy an out-of-favor business with solid fundamentals. Before deciding whether the stock is a buy or sell, be sure to examine the additional factors we discuss next. (Find out if your stock is on the verge of decline in Signs A Stock Is Ready To Slide.)
5. Profit Warnings
Investors should take profit warnings very, very seriously. While market reaction to a profit warning may appear swift and brutal, there is growing academic evidence to suggest that the market systematically underreacts to bad news. As a result, a profit warning is often followed by a gradual share price decline.
6. Insider Trading
Companies are required to report, by way of company announcement, purchases and sales of shares by substantial shareholders and company directors (also known as insiders). Executives and directors have the most up-to-date information on their company's prospects, so heavy selling by one or both groups can be a sign of trouble ahead. Admittedly, insiders don't always sell simply because they think their shares are about to sink in value, but insider selling should give investors pause. (To learn more, read Uncovering Insider Trading.)
The sudden departure of key executives (or directors), and/or auditors can also signal bad news. While these resignations may be completely innocent, they demand closer inspection. Auditor replacement can also mean a deteriorating relationship between the auditor and the client company, and perhaps more fundamental difficulties within the client company's business. Warning bells should ring the loudest when the individual concerned has a reputation as a successful manager or a strong, independent director.
8. SEC Investigations
Formal investigations by the Securities and Exchange Commission (SEC) normally precede corporate collapses. That's not surprising; many companies guilty of breaking SEC and accounting rules do so because they are facing financial difficulties. While many SEC investigations turn out to be unfounded, they still give investors good reason to pay closer attention to the financial situations of companies that are targeted by the SEC. (For more insight, see SEC Filings: Forms You Need To Know.)