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Stock
Risk Score Sheet
Economic reports signaling a slumping housing
market have raised fears that the overall economy could be slipping back
into recession. Whether that comes to pass is anybody’s guess.
Nevertheless, this is a time to be cautious—just in case.
While buying any stock involves risk, some
are riskier than others. Here’s a simple score sheet for evaluating the
risk of manufacturing and service stocks. It won’t work for banks and
other firms primarily in the business of lending money.
The process involves 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?
For a variety of
reasons, firms carrying significant debt are riskier than companies that
don’t. The debt/equity (D/E) ratio compares total debt to shareholders
equity (book value). A zero D/E signals no-debt and the higher the ratio,
the higher the debt. How much debt is too much depends on many factors.
Considering current conditions, ratios above 0.5 signal high risk. Add one
risk point for debt/equity (Total Debt/Equity on Yahoo) ratios above 0.5.
Too Small?
Because small firms don’t have the product diversification, financial
stability, or experience to cope with economic downturns, it’s best to
stick with larger companies in tough times.
Market capitalization (number
of shares outstanding multiplied by the current share price) measures
company size. Market-caps above $10 billion define “large-caps,”
market-caps below $2 billion are “small-caps,” the riskiest category.
Those in between are “mid-caps.” Add one risk point for stocks with
market-caps below $2 billion.
Profitable Enough?
Your best bets in any economy are stocks profitable enough to internally
finance their growth rather than resorting to borrowing or selling more
shares to raise needed cash.
Return on Equity (ROE) measures
profitability by comparing net income to shareholders equity (book value).
ROEs typically range from 5% to 25%.
But, most professional money managers look for stocks with at least 15%
ROE’s. Follow the pros and add one risk point for ROEs below 15%.
Smart Money In?
Institutional ownership is the
percentage of a company’s shares that are owned by large investors such as
mutual funds or pension plans. Because they
generate huge trading commissions, these big players have access to
information that we never see. The good news is that they have to
periodically report their holdings, so we know what they’re buying.
Institutional ownership figures
range from 40% to 95%
for in-favor stocks. 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, intending to buy
them back later at a lower price. They make money if they were right and
the stock price drops, but lose if it moves up instead.
While short-sellers can be wrong, the fact
that they are betting against a stock signals added risk. 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 average
daily trading volume.
For most stocks, short interest
ratios range between one and five days. Ratios above 10 days signal heavy
shorting activity, and thus, high risk. Add one risk point for short
interest ratios above 10.
Burning Cash?
Operating cash flow is the money that moved into, or out of, a firm’s bank
accounts resulting from its main business. Sometimes companies that report
positive earnings are, in fact, losing money when you count the cash.
Avoid these cash burners. Add
one risk point if operating cash flow is negative.
Overheated?
Hot growth stocks with great prospects always look overvalued.
However, at some point, even the best stocks reach unsustainable levels.
Most investors use the price/earnings ratio (P/E), which is the share
price divided by the last 12-months per-share earnings, to gauge value.
However, for a variety of reasons, you’ll get better results using the
“forward P/E,” which is based on analysts’ next fiscal year earnings
forecasts. There’s no hard and fast rule, but, in my experience, forward
P/Es above 40 signal problems ahead. Add one risk point for forward P/Es
above 40.
Using the Scores
Avoid stocks scoring three or more, and lower is better. You may
disagree with the specific numbers that I’ve suggested. That’s okay. Make
whatever changes you like. But using a score sheet like this will help you
make better investing decisions.
published 6/20/10 |
