Astute investors watch for warning signs that indicate when share prices are heading for a drop.
No matter which company you’re investing in, there’s always an element of risk. Anyone who tells you otherwise has found a crystal ball or is telling porkies.
If a company suddenly downgrades their profit forecast or a big contract unexpectedly falls through, there’s not much to do except brace for the inevitable (and immediate) fallout.
But astute investors watch for warning signs that indicate trouble ahead. And if you know what to look for, it’s possible to get out of risky plays before the real damage is done.
Here are five signs that share prices may be about to drop.
1. Trouble at the top
It’s important to keep track of what your employees (the management team) are doing at each of your investments.
Senior executives leaving unexpectedly, selling large quantities of shares or teams turning over too regularly sends a powerful message that things may not be as rosy as the company’s public relations spin would have you believe.
And if the people with the most to lose are jumping ship, maybe you should too.
2. Too much debt
If a company can’t meet its debt obligations, it’s in big trouble… simple as that.
The standard measure of a company’s debt level is its debt-to-equity ratio, which compares total debt to shareholder equity. A ratio of less than one means the company’s equity is worth more than its debt.
There’s no line in the sand for what constitutes ‘too much debt’ because it can change from industry to industry. It’s best to compare the debt-to-equity ratios for similar companies to see where your investment sits.
3. The market’s blowing bubbles
Markets aren’t always logical; sentiment, speculation and a herd mentality can all play a big part in influencing prices and pushing them higher than they should be.
A simple gauge of whether a share is overvalued is the price to earnings (PE) ratio. This is calculated by dividing a company’s share price by its earnings-per-share (EPS).
It’s essentially how much investors will pay for every dollar of its current profits. It’s most effective when used to compare similar companies to see where the market has valued then.
High relative PE ratios generally indicate investors expect decent growth in the future, but very high PE’s compared to its industry, or the overall market, can be a warning signal that prices have peaked.
4. The vultures (short-sellers) are circling
Short-sellers look to profit from falling share prices by borrowing shares in a company and selling them at the current market price.
If the price falls, they make a profit buying the shares back at the lower price and returning them to the original owner.
High levels of short-selling for a particular share generally indicates that part of the market believes the company is overvalued and the price will fall.
These beliefs can become self-fulfilling, as other investors get wind of the situation and either sell out or jump on the short sell bandwagon, pushing the share price further down.
5. Cash flow problems
The trouble with net income (profit or earnings) is that it’s an accounting figure. It’s not that hard for the finance boffins to push it one way or another to suit management interests.
Luckily for savvy investors, all listed companies are required to lodge a statement of cash flows that outlines the flow of cash in and out of the business, which is much harder to mask with financial trickery.
If a company’s cash flow from operating activities has dropped sharply but net income has increased, there could be an underlying problem that’s being hidden in the numbers, so it’s worth digging a little deeper.
But also keep in mind that markets can be volatile.
If you’ve done the sums and believe a company has great long-term potential, back your investment decision. Stay the course and don’t be swayed by emotion or irrational market behaviour.