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When NOT to Buy a Stock

Jul 26, 2022

When NOT to Buy a Stock

I was enjoying the rains while driving my 'dhano' aka Honda Activa to work. Good weather washed away my Monday morning blues.

My hand, automatically on its own, pulled the accelerator. And when I suddenly applied breaks because an auto rickshaw was going at the speed of an aeroplane, I fell!

I knew that vehicles often slip when it rains, but my hand! I scolded my hand and said, 'nahi karna tha!' (shouldn't have done that).

Now, this is something we realise only after doing something wrong. This late realisation often puts us in a regretful situation.

In share markets, this regretful situation is a red portfolio.

In volatile markets, avoiding losses is more important than making profits. Keeping your capital intact in the face of unpredictable markets is an achievement.

Investor should pay attention to overvalued stocks in India and also look at the top undervalued stocks in India to get an idea of the market.

Especially with the possibility of a recession, making sure you do not invest in stocks that can lose money is important. The don'ts have become more important than the dos.

So in this article, we bring pointers explaining when not to buy a stock.

Read on to find out what are the don'ts...

When NOT to Buy a Stock

When buying a stock, the most common mistake that many investors make is that they look only at the price of the stock.

While you must not buy a stock that stands on a verge of downfall, a potential investor should also look at other red flags.

An investor should pay attention to the following red flags:

#1 High debt

High debt companies are often considered growing companies. A company has higher financing needs when it is in the development phase.

However, high debt companies also come with high risks. In case a company suddenly goes bankrupt all its funds will go in paying the high debt. No money will be left with the company to pay back shareholders.

Another reason for caution in a high debt company is high-interest costs, which reduce profits. Now, this is a recurring and probable effect of having debts.

Hence investors should carefully analyse the debt level of a company, before buying a stock. Check if the reward from the growth is worth the risk of the high-interest costs.

Ideally, a debt to equity ratio of 1 or lower is preferred.

#2 Decreasing profit

Decreasing profits is often a sign of the declining health of a company. The company may perform well on the bourses due to external factors, but its internal operations may say otherwise.

A company may be running losses, yet the share price may be shooting up. For example, Zomato and Paytm last year.

Zomato and Paytm listed on the bourses at unbelievably high prices. But soon after their listing, the shares saw a sharp decline. Since then, these stocks have not been able to rise again.

Zomato share price is still falling. It hit a new all-time low this week.

Decreasing profits indicates that material uncertainties exist regarding the company's ability to continue in the foreseeable future.

Will the company sustain a dramatic increase in expenses or reduction in income? Will it stand firm in years like 2020-21 (pandemic years)?

If a horse cannot run ten miles, then how will it be able to run in a derby? Likewise, if a company cannot earn for itself, then how will it generate a return for its shareholders?

Owing to all these, investors should avoid such stocks. Even though the shares may be doing well on the bourses right now, they might fall anytime. They do not have fundamentals to back the rise in the stock price.

#3 Decreasing EPS

Earnings per share (EPS) will decrease in two cases. One, if the net profits available to equity shareholders decrease or the number of outstanding shares increases.

Now, we discussed what happens if profit decreases. Let us take a look at what happens if the number of outstanding shares increases.

Let us consider an example. Suppose your mother gives you Rs 100. She says you have to divide it equally with your best friend. So you are happy you both get Rs 50 each.

But then she tells you two of your cousins are coming home, and you will have to divide the amount equally between the four of you.

Now you might be happy they are coming, but you do feel a bit sad that you will get only Rs 25.

Similarly, when the number of outstanding shares is increased, its value will decrease because the earnings for your share are reduced.

Hence, an investor should avoid shares with decreasing EPS.

However, if shares are issued for cash, it means that the company is raising funds that indicates the development of the company.

Hence, an investor should carefully analyse the reasons for decreasing EPS.

#4 Low return on equity

Return on equity (RoE) means measuring what a company earned from the money it raised from equity shareholders. The formula for return on equity is net income divided by average shareholder's equity.

RoE is the company's ability to earn. Hence a low RoE indicates the company's inefficiency in generating returns.

Low RoE indicates two problems, poor allocation of capital and less investment from outside the company.

When a company depicts inefficiency, it will not be able to attract investment from outside because other companies might offer better returns.

Hence a low RoE indicates the company's weakness. Hence, its value might fall. So an investor must pay attention to RoE while buying stocks.

#5 Low promoter holding

Promoters' holding indicates what expectations the promoters have from the company's share price. If they expect the company to do well on the bourses, they will have a higher investment in the company.

If promoter holding is less, nobody else would trust the company to do well in the future.

Say, for example, I want to start a new business and I need a capital of Rs 1 m. I go to a bunch of friends and ask them to invest money in my business.

All agree that I have come up with a good business idea. But when it comes to investing money, the first question all my friends ask will be how much money I'm bringing into the business from my own pocket.

The reason was simple. My friends wanted to know if I trust my idea to work.

Similarly, if the company has low promoter holding, it shows that the promoters themselves do not trust the company to earn well.

#6 High PE ratio

PE ratio indicates what price per share the market is willing to pay for what the company earns per share.

Hence PE ratio is used to analyse if a company's share price is overvalued or undervalued when compared to the share's intrinsic value.

A higher PE ratio indicates the market price of the company is more than the earnings of the company.

Hence, the company is considered overvalued. Buying a high PE ratio stock is like buying pebbles at the cost of gems. It makes no sense.

It is believed that when a company is overvalued, the share price may fall in some time to match its intrinsic value.

Hence an investor should avoid high PE stocks. They are expensive. There is a possibility the stock will fall.

However, a high PE ratio is sometimes an indication of better performance and goodwill of the company.

For example, many blue-chip stocks have a high PE ratio because market participants are willing to pay more for them.

Investment Takeaway

Well, that is quite a long list, and yet it is not an exhaustive list.

An investor should study all of the above points but not in isolation. They should be considered cumulatively.

These ratios should be compared to the average industry too. This will give a wholesome picture of the company.

The irony is that even after painstaking efforts of analysing the stocks, there is no guarantee these stocks will generate quick and hefty returns.

In fact, stocks that fit all these criteria may generate slow returns. Only a business that is in the maturity stage can satisfy all these criteria. We all know quick returns come from companies in the developing stage.

The 'Not to Buy' for the stocks given here is important yet generalised. An investor should make his own 'when not to buy a stock' list.

He should perform a risk-reward analysis. He has to decide the amount of reward he is ready to accept and the amount of risk he is willing to bear.

I hope this list will help you make the correct decision.

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...

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