HomeMarket Workshop ] Stock Analysis Checklist ] Market Glossary ] Basic Training ] Best Investing Sites ] Death List ] Free Tutorials ]

Stock Risk Score Sheet

It’s easy to get carried away and throw caution to the winds in a strong market

To avoid that happening to you, here’s a simple score sheet for evaluating the risk of holding a stock. It 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.

High Debt?
Companies carrying high debt are always riskier than low-debt firms. The debt/equity (D/E) ratio compares debt to shareholders equity (book value). A zero D/E means no debt and the higher the ratio, the higher the debt. Given current conditions, ratios above 0.5 are high risk.

Add one risk point for debt/equity (Total Debt/Equity on Yahoo) ratios above 0.5.

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 $2 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 $2 billion.

How Profitable? 
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% ROE can’t internally fund more than 10% annual earnings growth.

Although you’ll find many exceptions, ROEs typically range from 5% to 25%. Most pros require at least 15% ROE before they’ll consider buying a stock. 

Add one risk point if return on equity is less than 15%.

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% to 95%. 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%.

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 mentioned earlier, is bad news for existing shareholders.

Add one risk point if operating cash flow is a negative number

Overheated?
Hot growth stocks 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 use the “forward P/E,” which is based on analysts’ next fiscal year earnings forecasts and do not include non-recurring costs. In my experience, 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 8/16/09

Questions or comments about this site:

Winning Investing   411 Palmer Avenue Aptos, CA 95003

(800) 276-7721 • (831) 685-1932

(Aptos is 'the beach' for Silicon Valley)