Sometimes (read: a LOT of the time), we have no idea that a company’s stock is about to crash. We think everything is great until, well, it goes boom.
Believe it or not, there are signs common among these instances that we can learn from. Often, stock crashes are precipitated by certain events.
They aren’t predictable, but some of the time, we can see them coming.
To experts, the warning signs are always written all over the place, but to a non-financial jargon, things always look fine; well, until they are not. But if the financial analysis is not your favorite part of investments, don’t worry, we’ll fix that in a moment.
How can you tell when a company’s stock is set to plummet?
1. Sinking revenue
A company’s share certificate can only mean something to the holder if the company has sufficient cash flow to sustain its operations.
Cash flow is a company’s lifeline; each and every investor should have a keen eye on the cash flow activities of the company they invest in.
If the same is reported for a longer period of time, it means the company’s bank accounts are being drained and it may soon be impossible to sustain the company’s operations. And more often than not, companies operating along these lines have two options; they can either raise additional funds from investors or lenders or shut down operations due to insolvency.
2. Debt / Equity ratio is lopsided
On its own, the Debt/Equity ratio does not reflect much of the company’s operations. Abbreviated as D/E, the ratio makes more sense when accompanied by an evaluation of the debt interest coverage ratio.
Consider this example:
An enterprise reports a D/E ratio of 0.60 during a certain quarter of the year which shows that the firm is safe from bankruptcy. In addition, the same company has an interest coverage ratio of 0.50. Interest coverage of less than 1 indicates the inability of a company to meet its obligations as they fall due in the reported period.
Further, an interest coverage ratio of less than 1 indicates that a company is not able to meet its debt obligations.
3. Alarming Debt-Equity Ratio
Distressed companies borrow at very high-interest rates due to their perceived risk by financial institutions. The huge repayments of loans taken can strain a firm’s cash flow, ultimately leading to a default in the repayments.
In this case, debt repayments end up draining any returns of the company, leaving little to no amounts being set aside as retained earnings which normally boost the capital base.
4. Downward trend of stock prices
The price of a company’s shares can speak volumes about its status. If the share price decreases when the industry is generally stable, it can be a sign of things going south.
More than 90% of companies that end up closing shop recorded a decline in share prices months or years before. For instance, Enron, which collapsed in 2001, had a peak share price of $96 only to end up with $0.26 by the time it was being wound up.
However, a sharp decline in the price of a company’s shares is not in itself an indicator of bad times ahead, it might be an opportunity to buy at a low and sell at a high later on. Be sure to include other parameters when analyzing the status of such companies.
5. Illegal trading (insider trading)
This is one of the surest ways for any reputable company to lose its public image. Most jurisdictions require companies to issue public reports in case of a purchase or a sale of a substantial amount of the company’s shares.
Directors and managers of a company have the most vital information about the status of the firms, any abrupt selling or buying of shares by one or two groups within the company can be a red flag.
When insiders sell their shares, it can be an indicator of tough times to come.
6. Profitability Warning
A Profit warning is a serious indicator of a company’s financial status.
Declining profits or increasing losses always cause an instant reaction in the market, with most investors opting to sell off their shares.
With time, the market systematically tends to under-react to the negative news. Consequently, negative news regarding a company’s profitability is mostly followed by a decline in stock prices.
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Companies that are facing problems are always investigated by regulatory authorities such as securities exchanges and tax authorities. These investigations normally precede a company that is about to undergo hard times.
It is not surprising to see companies break the law as a result of difficult financial or economic times.
And even if these investigations turn out to be unfounded, such authorities always leave the investors with more questions than answers regarding whether or not they should dispose of their shares in the company.
There are numerous other ways one can know whether or not the stocks of a company are about to go down. However, these are some of the key red flags you need to watch out for to enable you to avoid losing the value of your investment.
Of course, these metrics can only be relied upon to a certain extent.
There is also an interesting approach to protect you from sudden price losses overnight. In day trading, for example, you don’t hold your stock positions longer than a few minutes or hours.