Red Flags to spot while picking stocks! | 5paisa (2024)

Hey there!

So, let's talk about the one thing that scares the heck out of all investors. That’s losing investment in bad stocks.

Whether you are a big investor or just starting with a small portfolio; the fear of losing money is always there.

But don't worry! We're here to explain how you can avoid losing money on bad stocks. Get ready to explore the world of stocks and learn how to make the right moves.

The main rule is simple – know which stocks to avoid.

Firstly, stay away from companies drowning in debt and struggling to survive. These are the ones with a history of losing money, negative cash flows, and a growing pile of debt.

In a bull run, these companies might seem fantastic. Their stock prices go up, and everyone talks about how great they are – analysts, fund managers, and the media. But don't be fooled. Even if these stocks look good during a market boom, don't fall for them.

They might bring quick profits, but it's a risky game. You don't want to learn the wrong lessons by making money from a flawed strategy.

So, how do you identify these companies before they harm your portfolio?

Simple, my friend – turn to the online financial portals.

Check the debt of the company – if it's high, proceed with caution.

Here's a quick checklist:

EPS > 0 (It means the company is making a profit)
Debt-equity ratio < 0.1 (It means the company has relatively low debt)

If a company boasts profits, minimal debt, or even a cushy cash reserve, consider it safe.

There are always exceptions. Now some companies operate in sectors that require huge capex and have high debt, for example, automobile, and infrastructure companies in these sectors would have high debt on their balance sheets. In cases like these, you have to ensure these things:

• The company is increasing its revenue every year.
• The company is profitable and is increasing its profits
• The company has healthy return ratios.
• The company has a healthy interest coverage ratio. This ratio tells you whether the company is making enough to repay its interest.

A high D/E ratio is a red flag. It reflects that a company is overly dependent on debt, spelling financial risk.

However, a little debt isn't a deal-breaker, especially for sectors like IT where D/E ratios rarely hit zero.

Aim for companies with a D/E ratio between 0-0.5 to eliminate high-debt headaches.

Now, let's talk about profitability and valuations. Check metrics like Net Income, ROE, ROCE, EPS, and operating margins. A company swimming in profits attracts investors like bees to honey.

A safe ROCE range of 15-20% caters to investors with a low to mid-risk appetite.

Beyond the basics, explore other financial metrics, like the operating cashflow of the company, and corporate governance policies.

Another major factor that you need to consider is the industry growth and competitive advantage. Ask yourself these questions:

Is the industry flourishing or withering away? Identify growth drivers, potential challenges, and headwinds.

Long-term investments hinge on industry growth, so make an informed decision.

Consider the aftermath of 2020 – the pharmaceutical industry's surge due to COVID-19. People's health concerns fueled industry growth and that was reflected in rising stock prices of pharma companies. Evaluate the industry's outlook and potential for expansion.

Now, peek into the arena of competitors. A peer comparison unveils the best players. Assess whether the company stands out with unique strengths. This way, you get a front-row seat to the crème de la crème in the sector.

After you have done it all, don’t just jump into the stock with all your hard-earned money. Even a good stock bought at a high valuation is a bad investment. So, you need to check the company’s price-to-earning ratio. If the stock is trading at a decent valuation then you might consider investing in it but don’t burn your money by investing in stocks that are overvalued.

In the end check some technical indicators – moving averages, support and resistance levels, and volume patterns. These indicators will guide you in getting the right entry point for the investment.

Now you do not just forget the company after investing in it.

Stay in the know with company news, industry developments, and macroeconomic factors. Don't drown with a sinking ship if a bad event unfolds.

In the end, consider checking the research reports and ratings from trusted analysts. These reports often have critical details about the company's business and since these are created by expert professionals, these will guide you in your investment decisions.

And oh, never forget your own risk tolerance and investment goals – they're the North Star guiding your decisions.

In conclusion, weave these factors into your selection process, and you're primed to navigate the market with savvy investment decisions. Remember, while stock screening isn't foolproof, vigilance is your best ally. Think wisely, invest smartly, and always keep your best interests in mind.