How to identify a bad stock? Beginner's guide to share market

Date : 08/10/2021
Read: 5 mins

Here are the potential red flags you need to look out for when evaluating a stock for investment.

Investing in the stock market is as much an art as it is a science. Stock market investing for beginners can be confusing, with a barrage of overwhelming information from various sources. Many beginners try to get onto investing trends and ride the wave. While they could make money in the short run, this is purely based on luck, and it can turn out to be an expensive way to learn a tough lesson if you end up investing in a bad stock.

Fundamental, unbiased analysis of a business, risk-reward assessment, and periodic monitoring are some of the tools you can use to identify a bad stock - or get out of one. Read on for a beginner’s guide to stock market trading.

1. High debt-to-equity ratio

Businesses borrow money for a variety of reasons, and just like everyone else, they have to pay interest on that money. Companies that have a high amount of debt can end up losing a significant portion of their revenue servicing this debt, which directly impacts profitability.

If revenues decline during unpredictable times or a market downturn, it could jeopardise the entire business, and the stock prices could come tumbling. Checking a company’s debt-to-equity (D/E) ratio is one of the primary stock market tips for beginners. Companies that have a D/E ratio higher than 1 are considered very risky and should be avoided. Ideally, you should invest in businesses that have a D/E ratio below 0.5. Low debt on the balance sheet denotes greater creditworthiness and lower risk.

2. Low return on capital employed

Building upon the point mentioned above, low debt or high equity capital in itself cannot be a determinant. Investors also need to see how the business is utilising the capital. For example, assume Company X has raised Rs 200 crore capital and generates a profit of 9%, and Company Z has raised Rs 500 crore capital and generates a profit of 12%. On the face of it, it may seem as if Company Z is generating more profits, but when you assess gains basis the capital employed, Company X is doing much better.

On the other hand, a high return on capital employed (ROCE) indicates the management is judicious and is able to make maximum use of capital. However, when comparing businesses, always do so within the same industry and over a period of at least 3-5 years to get a better picture.

3. Profitability and sales growth

While the past performance of the business is an important consideration, your investment should be driven by what promise the stock holds for the future. Sales and profit growth is an indicator of improving business efficiency and competitiveness.

An essential tactic of investing in stocks for beginners is to assess the year-on-year growth of the business. Avoid stocks that have been unable to scale up over the last 3-5 years or even businesses that show growth in sales but not overall profitability. Be careful about risk on the other end of the spectrum as well - a business that shows unusual profits not justified by business activity or market changes should also be investigated thoroughly.

4. Suspicious promoter activity

Promoters are usually the largest shareholders of the company and obviously clued into every single thing that happens behind closed doors. Promoters’ activity on their own stock can give a fair idea of how they perceive things to change. There have been many instances of insider trading and stock manipulation that makes the promoters rich at the cost of unsuspecting investors.

Investors need to be wary of ‘pump and dump’ stocks, where promoters or large investors try to hype stock prices by circulating false or misleading ‘positive’ information that triggers a buy from investors to later dump their own stock at inflated prices and jump ship. Conversely, an increase in promoter shareholding is usually a good sign. The promoters think that the stock is undervalued and feel that putting money where their mouth is would pay better dividends.

5. (Mis)management issues

The management team is responsible for running the business and creating shareholder value. Investors should keep a keen eye on what the management does rather than what the management says. Straying away from business core competencies, overpaying for assets, increase in salary not justified by business growth, large-scale lay-offs, regulatory issues, undermining opinions of shareholders, etc., are some indications that could save you from investing in a bad stock.

It is important to know who is running the business you have invested in. Frequent changes in the top management is an indication that things may not be going well. There are examples of many CEOs of blue-chip giants whose words, actions, or incompetence has eroded shareholder value despite the business demonstrating sound fundamentals.

6. Red flags in footnotes

The very first piece of advice on how to invest in stock market for beginners emphasises on going through the financial report of the business. Everything regarding the company’s performance is laid out in black and white. However, many businesses try to window-dress their performance, which can be missed by a novice.

As the old saying goes, ‘The devil is in the details’. The footnotes of financial statements should clarify all the fine print - the accounting method used, details of the debt, ESOPs, legal issues, and more. A switch between accounting methodology, inaccurate revenue reporting, unusually higher legal fees, etc., are red flags to look out for.

Some companies are also known to use legal jargon and technical terms in the footnotes to confuse investors. If you feel there’s more than what meets the eye, you are better off looking at some other stock to invest your hard-earned money.