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Stock
Risk Score Sheet
Everybody knows that buying stocks involves risk, but
some stocks are a lot riskier than others.
Here’s a simple score sheet for evaluating the risk
of stocks that you already hold or are considering buying. The score sheet
consists of seven tests. For each test that a stock flunks, add one risk
point. A perfect score is zero, and the higher the score, the riskier the
stock.
You can find the needed data on many financial sites.
On Yahoo Finance (finance.yahoo.com),
the Key Statistics report includes everything you need. Find it from the
Yahoo Finance homepage by getting a
price quote,
and then selecting
Key
Statistics.
Too Much Debt?
For reasons I don’t have room to describe here, companies carrying high
debt are riskier than low-debt firms.
The debt/equity (D/E) ratio compares a firm’s debt to
its shareholders equity (book value). A firm with n debt would have a zero
D/E, and the higher that debt, the higher the ratio. Generally companies
with ratios above 1 are considered high debt.
Add one risk point for debt/equity (Total Debt/Equity
on Yahoo) ratios of 1 or higher.
Too Small?
Small companies are inherently riskier than larger firms. They typically
don’t have the product diversification, financial stability, or
experience, to ward off new competition or economic downturns that bigger
firms do.
Market capitalization (number of shares outstanding
multiplied by the current share price) measures company size. It’s how
much you’d have to pay to buy all of a firm’s shares. Companies with
market-caps above $10 billion are termed “large-caps,” firms with
market-caps below $1 billion are “small-caps,” and those in between are
“mid-caps.”
Small-caps are the riskiest category, so add one risk
point for stocks with market-caps below $1 billion.
Not Profitable Enough?
The best stocks are able to finance their growth from profits rather than
via borrowing or selling more shares. Both of those alternatives reduce
the value of existing shares.
Return on Equity, a widely used profitability gauge,
is net income divided by shareholders equity (book value). The way the
math works, a company can’t internally fund annual earnings growth more
than its ROE. For instance, a firm with 10 percent ROE can’t internally
fund more than 10 percent annual earnings growth.
Although you’ll find many exceptions, ROEs typically
range from five percent to 25 percent. Most pros that I’ve talked to
insist on at least 15 percent ROE before they’ll consider buying a stock.
Add one risk point if return on equity is less than
15 percent.
Smart Money Missing?
Institutional ownership is the percentage of a company’s shares
that are owned by mutual funds, pension plans, and other large investors.
Thanks to the huge trading commissions that they generate, these big
players have access to inside information that we will never see. For in
favor stocks, institutional ownership figures range from 40 percent to 95
percent. If the number is lower for your stock, it probably means that the
smart money knows something that you don’t.
Add one risk point if institutional ownership is less
than 40 percent.
Short Sellers Swarming?
Short sellers think that a stock is more likely to go down than up. So
they sell shares that they’ve borrowed from a broker with the idea of
buying them back later at a lower price. They make money if they were
right and the stock price drops. But they lose if the stock price moves up
instead of down.
Short-sellers are usually expert fundamental
analysts. While they are not always right, it’s risky to bet against these
savvy players.
Short interest is the number of shares that have been
borrowed by short sellers for their trades. The short-interest ratio is
the number of days it would take for the short sellers to buy back their
borrowed shares, based on the recent average daily trading volume.
For most stocks, short interest ratios range between
one and five or six days. Ratios of 10 or more signal heavy shorting
activity, and thus, high risk.
Add one risk point for short interest ratios of 10 or
more.
Burning Cash?
Operating cash flow is the money that moved into, or out of, a firm’s bank
accounts resulting from its main business. Thanks to flexible accounting
rules, some companies manage to report positive earnings, when in fact;
they are losing money when you count the cash.
Negative cash flow adds to risk because these firms
are going to eventually run out of cash. Then, they’ll have raise more
cash, which as I pointed out earlier, is bad news for existing
shareholders.
Add one risk point if operating cash flow is
negative.
Overheated?
Hot growth stocks with great future prospects always seem overvalued by
traditional measures. However, at some point, even the best stocks reach
unsustainable levels.
The price/earnings ratio (P/E), which is the recent
share price divided by the last 12-months per-share earnings, is the most
widely used valuation measure. However, non-recurring charges, such as
expenses associated with an acquisition, can artificially reduce earnings,
and thus, distort the P/E.
Consequently, I prefer to use the “forward P/E,”
which is based on analysts’ next fiscal year earnings forecasts, which do
not include non-recurring costs. While there’s no hard and fast rule, I’ve
found that forward P/Es of 40 or higher frequently signal problems ahead.
Add one risk point if the forward P/E is 40 or
higher.
None of the risks I’ve described here are subtle or
obscure concepts. You probably already knew about most of them. But using
this score sheet will keep you from overlooking them when you’re analyzing
stocks.
Risk averse investors should avoid stocks scoring
three or more, and lower is better. All investors should rule out stocks
scoring five or more.
published 4/15/07 |
