9 Ways to Identify Bad Stocks

Do you remember the Satyam Computer Services scam from the year 2009, the Sahara scam of 2014 or maybe the Kingfisher fraud of 2016? And the master of all frauds, the Lehman Brothers Holdings Inc in 2008 which literally was one of the major causes of the global recession back then. 

Like these, there are thousands of scams that happen around the world. Let alone in India which is like a hub for banking scams be it ICICI- Videocon scam, ABG Shipyard fraud, PNB fraud, SBI and the list goes on. The black cloud of scams, frauds & financial crises doesn't seem to fade away. 

Not only the stakeholders associated with these companies are affected, but the shareholders such as customers, employees etc in these companies are also affected with the same intensity. 

This was all about the scams. But there are few companies that may not be indulged in fraud but are engaged in mismanagement such as not utilising profits properly, being very much reliant on debt and so on.  This also adversely affect the shareholders. Thus, today we are going to look at some ways by which you can spot these mischiefs. So, let's get started. 

What are Bad Stocks?

Bad stocks or the villains to your good investments. These are, as the name implies the ones that may have poor management, excessive debts, way too much promoter pledging, declining profits, inability to generate cash, inability to manage profits, too much spending on working capital requirements and whatnot. 

Identifying the best stock for yourself is so important. Although it's a long process, before jumping into analysing the financials of the company one should understand what the business is all about. Now identifying the best ones has become a cakewalk with Finology Ticker. Which is a stock screening tool where you can do all your company analysis before making an investment decision.  

Today, we are going to share with you various ways to identify sceptical stocks with the help of  Ticker. 

We love using this tool, we hope you do too. Without waiting anymore, let’s start with the topic that brought you here. 😛

Ways to recognise Bad stocks

1. P&L vs. Cash Flow Statement

P&L & Cashflow both are very important statements when it comes to Financial Analysis for any company. P&L basically tells about the net sales, total expenditure, taxes, net profit and more. Thus, in a nutshell, the profit and loss statement tells you the figures for sales and the profit earned on it. 

But this statement is filled with shortfalls as the actual cash inflow and outflow is not clearly differentiated from credit income and expense and those shortfalls are completely covered in the Cashflow statement. 

Imagine you sold a company of Rs. 100 and the customer is going to pay this amount after 30 days but this transaction is recorded in the books before receiving the actual amount. But it's not necessary that this payment will be received on time or the chances are, it might not be received at all! Thus, the Cashflow statement will tell you when you received the actual payment as it tells you about the actual inflow & outflow of cash. This statement will let you spot those companies that are not receiving cash in the actual sense.  

Go to Finology Ticker, pick a stock and check its cash flow statement.

Add the last 5 years of Operating cash flow then add the last 5 years' of Net profit from the P&L statement and compare both the amount. If both the amounts are close then it's a good sign. If not, the company cannot collect its credit timely, which might be alarming if stretched for a longer duration.

2. Market cap vs. Enterprise value

Let's understand it this way. If you want to be a 100% owner of any company then Market Cap would be like the total amount of money you have to pay for buying that company. Market cap is calculated by the company's stock price multiplied by the no. of shares. 

With this, you will get to know the size of the company. Now, what is enterprise value you might ask? It is derived from the market cap. It tells you about the total value of the company plus debt, minus any cash the company has. So enterprise value will tell you the true picture of the debt of the company. Its formula is Market cap + Market value of debt - cash & cash equivalents. 

Let's take the example of Ashok Leyland Ltd. The market cap of Ashok Leyland as of 4th March 2022 is ₹ 31,072.56 Cr. and its enterprise value is ₹ 33,978.36 Cr. If you want to be the 100% owner of Ashok Leyland Ltd. you have to pay ₹ 31,072.56 Cr. but in this case, you will also get the debt of the company which is reflected in the enterprise value. Thus, if the enterprise value is way more than the market cap of the company, then it can be an alarming sign. 

3. Consolidated vs. Standalone 

Standalone Financial is the statement showing the numbers of a single entity. By analysing the financials of only the standalone, investors will not know about the position of its subsidiaries which might affect the investment decisions. 

On the other hand, Consolidated Financial statements are the financial data of a company with multiple divisions or subsidiaries. Thus, take into consideration the consolidated financial statements of any company. In Ticker, you can easily find the Consolidated as well as Standalone data of any listed company.

4. Beware of Rights Issue

A rights issue is the issue of shares offered at a special price by the company to its existing shareholders in proportion to the holding of old shares. If we don't think deeply about this it's clear that the company is offering shares at a discount which is good for its existing shareholders. But Rights Issue is not the best practice altogether. 

Let’s suppose a company whose net profit is 500 is issuing rights and the no. of shares outstanding before the issue is 100. On the other hand, the no. of shares outstanding after the rights issue becomes 300. Still, the net profit remains unchanged i.e 500.

In this case, the EPS or earning par share is reduced which is not very good news for its shareholders. 

5. Dividend yield

A dividend is the part of the profit that the company gives back to its shareholders on a regular basis. Dividend Yield is the ratio that tells you the percentage of dividend a company pays out in relation to its share price.  A slow-growth company such as PSU have a higher dividend yield but a fast-growing company tends to have a lower dividend yield. 

Let’s take an example of Coal India the 5-year CAGR of which is -10% but its dividend yield is 8.84% as of March 2022. On the other hand, there is Info Edge whose 5-year CAGR is 39.4% But its dividend yield is only 0.18%. Thus, it has to be remembered that a company that gives a higher dividend might imply that it is not utilising its profits for growth. 

6. Debt to Equity ratio

If a company has very high debt then it means that the companies debt value is more than its asset value which is not a very good sign. On the other hand, if a company has low debt, its asset value is more than its debt value, which is a great sign. Thus, one should ignore such companies whose debt value is way too much. Ideally, it is said that the debt to equity ratio should be less than 1 for a company to be sound.

The debt to equity ratio also depends from industry to industry, for eg. it's normal for working capital intensive companies to be high on debts. On the other hand, if you have a service or technology company then it can be low on debt. Thus, the debt to equity ratio should be compared within the same industry.

7. Interest Coverage Ratio

This ratio tells us how efficiently the company is paying the interest charged on its debts. It is observed that a high-interest coverage ratio is a good sign. On the other hand, if the interest coverage ratio is less than 1 then it can be said that the company is struggling to pay its debts. Due to the absence of cash.

In this case, the company's chance of bankruptcy is very high. Again compare this ratio in the same industry. As it can also happen that some capital-intensive companies have lower interest coverage ratios, on the other hand, some tech-driven companies have higher interest coverage ratios. 

8. Promoter Pledging

Promoters are the owners of the company at the time of its incorporation and generally, promoters have the majority of stake in the company.  A company requires funds for expansion. They can do it by raising equity capital or corporate bonds or through loans from banks. If in case the company chooses to take a loan then they have to provide collateral to the bank and in that case, the company can provide the promoter’s stake as collateral and this is known as promoter pledging. 

It's a common practice, still, if you are analysing a company and if you find any promoter pledging then you should understand the risks involved in this. For eg. sometimes companies that take the bulk of loans can indulge in the practice of excessive promoter pledging. In this case, the management of the company can also lose its managerial power and company control if they are unable to repay the loan back. Guess what? You can also check promoter pledging as seen in the image below. 

Ideally, it's said that the promoter pledging of any company should not be more than 30%.

9. CFO/PAT

Any CFO or cash flow from operating activity tells you how much cash is generated in that company. If the CFO is consistently positive every year then it's a good sign. On the other hand, if the CFO is less than the PAT of the company then it can be a red flag. It implies that a company's working capital requirement is huge and a lot of profit is going towards working capital requirement. Ideally, CFO/PAT should not be less than 1. 

The Bottom Line

Identifying the best stock to buy is an art and so is to identify a bad stock. Nevertheless, Finology has sorted all of it for you Here! 

Also, Is there any topic you want a blog on or do you have any queries related to this blog? Then write us at support@finology.in We love it when you communicate with us. Do write in the comment section if you liked the blog.. :) Until then, Happy Investing.