When a highway ramp leads into oncoming traffic, warning signs keep drivers from going the wrong way. That usually gets the job done.
But when a particular stock poses danger, the signs aren't always so evident. So, what are some warning signs investors might consider to help them tell a good stock from a bad one?
5 ways to tell a good stock from a bad stock
Failure to meet numbers
First, find out whether the company you're considering has issued any recent earnings warnings or failed to meet analysts' earnings expectations more than once in recent quarters. Either may be a red flag.
Although no company can always perfectly predict how a quarter might go, it's important to see that the firm has a decent track record of conforming with both its own and analysts' expectations. Failure to do that might indicate either disorganization within the company or failure by company leaders to respond to changes in industry dynamics. You may not want that.
The other possibility is that the company might be in a very volatile industry that no firm could have much control over. That's not always a bad scenario, because volatility can sometimes mean the chance for greater returns, but if you don't like a roller-coaster ride, it might be better to stay away.
How can you check if a given company delivered on financial estimates over the last few quarters? Log in to your account at schwab.com, select Research, and then input the stock symbol. Under the Earnings section, you'll find an overview of the company's recent earnings report, including whether it beat (green up arrow) or missed (red down arrow) analysts' expectations.
You might also want to check the Ratings section for the company, which can tell you how analysts are viewing quarterly performance, what issues the company faces, and whether analysts believe it's on the right path to resolve them.
Weakness vs. peers
Another important section on the Schwab Research page is the Peers & Ratio Comparison feature. When you scroll down in this section, it charts how your stock compared with key industry peers. Metrics such as earnings growth, price-to-earnings (P/E) ratio, and profit margin are key data to help you smoke out possible danger signs in a stock.
Traders often compare a stock to its sector and see how it's doing compared to other stocks. Case in point: the P/E ratio. If your stock has the highest P/E, it might deserve a deeper look. For example, a stock that has a P/E of 15 or higher or a dividend lower than 2.5% might present reasons for skepticism.
Other warning signs might include lower profit margins than a company's peers, a falling dividend yield, and earnings growth below the industry average. There could be benign explanations for any of these, but you need to do a bit more research to make sure they don't point to any red alerts that might mean future share weakness.
For illustrative purposes only. Past performance does not guarantee future results.
The stock doesn't meet your objectives
Some danger signs might not be with the stock, but with you. The company may be doing nothing wrong, but if you invest hoping for major sales and earnings growth, then accidentally choose a mature company in a mature industry, you'd own that mistake. The same is true if you buy shares in a company but don't take time to really figure out what it does.
As a general rule of thumb, investors need to understand how a company makes money. If you can't see it, you might want to re-think investing in it.
Additionally, it helps to evaluate possible outside risks that even a solid company might face. Look into the industry a bit, read some recent news articles and analyst reports, and see if you sense danger signs. Even if a company seems to be dominating its industry, you wouldn't want to invest if it's the equivalent of buying the best horse and buggy maker. Again, the Ratings section on schwab.com might offer a sense of what's driving the company and its industry.
Trend isn't always your friend
It's also important to understand your motivation for investing in a particular stock, because sometimes you may let emotions and perceptions get in the way of figuring out if it's a good investment.
This often happens when a stock is in a high-flying industry that's getting a lot of attention and drawing excited investors. There's often a sense of not wanting to miss out. But that's another danger sign.
One example of investors investing emotionally was during the "dot-com" boom, when many investors threw caution to the wind and leaped into internet stocks without really figuring out how or whether these companies could ever generate cash flow or profit. In some cases, investors loved the product they were using and may have decided the rest would naturally follow. Turns out that's a common fallacy.
Great products don't always make great investments. That underscores the need to do legwork before making an investment.
Poor chart action
There are also some danger signs of a more technical nature that you might be able to see on charts.
For instance, experts often tell investors to try to buy a stock when it's relatively cheap. But picking a bottom is a fool's game—there's never certainty in the stock market—though it sometimes pays to be patient and watch the charts carefully before swooping in.
Additionally, watch for a trend. Wait for the stock to rally a few days in a row to avoid what's called a dead cat bounce. That typically has the stock bouncing for a day before it plummets amid active short covering.
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
*Earnings data/research is provided by unaffiliated third parties.
This material is intended for informational purposes only and should not be considered a personalized recommendation or investment advice. Investors should review investment strategies for their own particular situations before making any investment decisions.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.1222-2T4J