12 Ways to Identify Bad Stock

Published November 7, 2022

Finding the right stock for investment from 300+ stocks in Pakistan Stock Exchange is not an easy task.

While there is no right or wrong stock in Pakistan Stock Market, it depends on your investment objective and the strategy based on which a couple of stocks will be appropriate for you!

How to select the right stock?

Instead of trusting advice from peers and brokers, we encourage you to read news from trusted sources, and research company financials and news releases.

While selecting the right stock according to your investment strategy, you must take care of the bad stocks which YOU SHOULD NOT BUY!

These stocks belong to the companies where mismanagement is found such as not utilizing profits properly, relying very much on debt, and so on.  This unfavorably influences the investors.

How to identify a bad stock?

A variety of “warning signs” may be present which indicate that a stock poses an excessive risk for investors. These stocks can induce a high-risk investment and most likely a drop in prices.

Look for these 12 warning signs in the company’s financial history and you are set to decide about its selection:

1. High Debt

The company has more liabilities than assets. This is typically viewed as an exceptionally perilous sign proposing that the firm is at risk of failing and is in danger of going bankrupt.

What occurs when a business has excessive debt?

A company is supposed to be overleveraged when it has too much debt, hampering its ability to make principal and interest payments and cover operating expenses. Being overleveraged leads to a downward financial spiral resulting in the need to borrow more.

2. Declining EPS

Earning Per Share, a popular statistic for determining corporate value shows how much money a firm produces for each share of its stock. Because investors will pay more for a company’s shares presuming the company has larger earnings relative to its share price, a higher EPS suggests more value. Lower or declining EPS reflects the company’s bad financial condition, which lowers investment returns. Additionally, it paints a dim picture of the company’s prospects for future growth.

Investors should be aware of the dangers involved when purchasing stock in a company with a negative P/E ratio because they are purchasing shares of an unproductive business.

3. High P/E

The Price-to-Earnings ratio is very helpful in pursuing investment decisions. It tells about the stock price value in comparison to its earnings.

A stock with a high PE ratio is costly and may see a decline in value in the future.

A stock is considered cheap and may increase in value in the future if the PE ratio is low.

However, companies having high growth potentials such as technology companies have higher P/Es. This shows that investors are willing to pay a higher share price because of growth expectations in the future.

4. Decreasing Profits

The profit margin is a top-level indicator of a company’s potential and has become the internationally accepted standard measure of its ability to generate profits.

Profit margins are viewed as indicators of a company’s financial stability, management ability, and potential for growth by both investors and businesses themselves. When comparing the numbers for various businesses, it is important to keep in mind that profit margins differ by industry sector.

What leads to a drop in profits?

Low profitability is typically caused by high operational costs, low income, or, most often, a combination of the two. Excessive costs are frequently caused by ineffective operational procedures.

5. Low Return on Equity

A company’s ability to create income from the capital invested by its stockholders is measured by its return on equity (ROE). A high ROE indicates that a business’ management team is more effective at using investment finance to expand the company (and is more likely to provide better returns to investors). However, a low ROE suggests that a business may be poorly run and may be investing profits in underutilized assets.

A higher ROE indicates that a company is effectively using its shareholders’ equity to generate income. A low ROE indicates that the company earns little in comparison to its shareholders’ equity.

6. Less Promoters Holdings

Anyone who actively contributes to the development of the business and has control over how it runs is a promoter. They might hold high positions in the company and have varied stakes in it.

The percentage of the company’s shares controlled by the promoters is known as their “promoter holding.” A declining promoter ownership gives investors a bad impression by demonstrating that the promoters themselves have little faith in the company’s future. Investors may be alarmed by the promoters’ engagement in the day-to-day operations of the company, in particular.

The promoters occasionally need to sell their stakes to cover personal needs or to fund an investment in a new business. Knowing the reasoning behind the share’s liquidation is therefore crucial. If there is a plausible explanation, there is no reason to worry. A sharp decline in promoter holding, though, can be the reason for concern.

7. Executive Turnover

The removal of a CEO by the board of directors of a firm is never graceful. Investors frequently assume that the company is doing extremely poorly or is otherwise likely to hit the rocks. They very likely have it right. Investors are typically more at ease with new CEOs who are knowledgeable about the dynamics of the sector and the unique difficulties the firm may be experiencing.

Reputation is crucial, especially when investors are evaluating the CEO’s track record of generating shareholder value.

8. Profitability & Sales Growth

Your investment should be motivated by what the stock has to offer in the future. Avoid stocks that have struggled to scale up in the last 3-5 years, as well as enterprises that have increased sales but not overall profitability. If sales growth is high, it will reflect increased income so that dividend payments tend to increase. Keep an eye out for the company’s sales growth in order to earn better dividend payouts.

If the company is staying in the same stage for the last 5 years, that means there is little to no chance for the company to expand its operations and give good payouts to its shareholders.

9. Mismanagement Issues

Regulatory concerns, large-scale layoffs, overpaying for assets, and deviation from key business strengths are a few warning signs that could prevent you from buying a terrible stock. Companies often face management issues and these issues are often very bad for their long term business profitability hence they are mostly unable to provide profits for their shareholders.

Our world is changing quickly, especially for businesses. It’s critical to keep in mind that in just one generation, businesses had to adapt to entirely new marketing channels (the web and social media), decide how to invest in and use new technologies, and compete on a global level—things that were hardly even conceivable to our parents’ and grandparents’ generations. Watch out for any potential problems the business may be having.

10. Red Flags in Footnotes

Financial statement footnotes should clarify all the fine print – the accounting method used, debt details, legal issues, and so on.

To identify this red flag you need to check :

• Revenues that have steadily declined over time.
• A D/E ratio that is steadily rising.
• Volatile cash flows are one example.
• Rapid swings in share prices on the stock exchange.
• Any ongoing legal action brought against the business.

11. Beware of Rights Issues

A rights issue occurs when a corporation offers current shareholders discounted shares in proportion to their holdings of old shares. This favor to shareholders indicated that something wrong is going down in the company as to why they would be giving reduced share price and actually be in loss.

For companies, the fundamental concept is to raise new funds. A corporate organization rarely uses a rights problem as an excuse. Ideally, a problem like this arises when a business needs money for corporate growth or a significant takeover. However, businesses also employ rights issuance to keep themselves from going bankrupt at the same time.

12. Interest Coverage Ratio

This ratio indicates how effectively the company pays its debt interest. If, the interest coverage ratio is less than 1, the company is struggling to pay its debts, due to a lack of funds. Avoid such companies. While a company is struggling to pay its debts, it’s highly unlikely for the company to give away decent profits to its investors.

 

Concluding Note:

Companies face tons of issues in their operational time period but they are never transparent. However, an Investor can check if the company they are about to invest in is on right track or not. With the above-given research points, investors may now easily identify the bad stocks

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