Investing in stocks is one of the simplest and most lucrative ways to grow your wealth over the long-term. It’s no coincidence that most members of the Forbes 400 list of the richest people own large quantities of shares in public or private businesses. While stocks can be profitable for smart investors, failing to heed the red flags can be a recipe for financial ruin.
Reduced Stock Prices
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Stock prices rise and fall with market movements. While some fluctuation is normal, falling share prices is one of the first signs of company failure. For example, the price of Enron stocks started dropping 16 months before the company’s collapse. While some businesses recover from falling stock prices, marked drops are a red flag you shouldn’t ignore. As a guide, you should be wary of businesses with stocks that have dropped by 15 percent or more, or stocks that have fallen to less than $10 a share.
Conversely, rising stock prices can indicate a solid investment. For example, stocks listed on the U.S. Marijuana Index posted price increases of more than 71 percent between June 2017 and June 2018, much more than the 12 percent gains of S&P 500 companies during the same period. The best marijuana stocks posted some of the greatest price increases.
Lower Company Dividends
Beware of plunging company dividends. John Divine, a senior investing reporter for U.S. News & World Report, suggests that once dividends fall, “the stock will almost assuredly tank.”
Consider the case of General Motors, once an automotive superpower with blue-chip stock. In 2006, it halved its dividend to 25 cents per share. This was the red flag that should have alerted existing investors to sell. Two years later, it eliminated its dividend altogether — an even brighter, bolder red flag. General Motors filed for bankruptcy in 2009, leaving its shareholders without even the value of their original investments.
High Debt-to-Equity Ratio
A company’s debt-to-equity ratio is an excellent indicator of its bankruptcy risk. It compares a company’s long- and short-term debt to its shareholders’ equity.
High-risk companies will pay higher interest rates to borrow money as they’re at the greatest risk of defaulting on their loans. Consequently, debt typically reduces their returns. On the flip side, lenders will grant lower interest rates to secure businesses they feel are most likely to repay their debts. These low rates help these stable businesses have much lower debt-to-equity ratios.
The lower the debt-to-equity ratio, the more secure the business. However, you can’t compare apples to oranges. Investopedia notes companies in capital-intensive sectors usually have much higher debt-to-equity ratios than businesses in less capital-intensive sectors. For example, auto manufacturers usually have ratios greater than two, while tech companies will often have debt-to-equity ratios of less than 0.5. Compare the ratios of companies within the same industry to make the right investment decisions.
Not all stocks are created equally. Remember to analyze the businesses you’re interested in and its financial portfolios, both before buying shares and at regular intervals during your investment period. Let any red flags you find guide you toward making the right investment decisions.