Stock Analysis: Long-term Prospects – Red Flags
The future is uncertain and it’s a very difficult task to know the general long-term prospects of a business. However, an intelligent investor can look for signals and warning signs that could guide his analysis in terms of what the future holds for the company. Some of these red flags or warning signals are discussed below:
1. The company is a serial acquirer
When a company has surplus cash one of the ways that it uses it is to expand by way of acquisitions. However, acquisition is a difficult business and unless there are serious synergies, growing by acquisition is risky. At the same time, a one-off acquisition is okay, but what if the company keeps acquiring businesses one after the other. One way to look at it is that the company considers other company’s stocks more valuable than its own otherwise it could have used some of its cash for buying back its own shares. One more important point is that more often than not companies overpay for acquisitions thereby depleting their own overall value. So, when you see a company as a serial acquirer you need to question the long-term impact of this and exercise caution while valuing such a company.
2. The company is an OPM addict
In other words, instead of generating money from its business, the company is constantly bringing in other people’s money (OPM) in the form of borrowings or by issuing more stock. Such activity can be easily identified by looking into the statement of cash flows. Look for how much of cash flow is from operating activities versus from financing activities. More cash flow from financing activities compared to cash flow from operating activities is a warning sign unless you can justify the growth prospects.
3. The company has just one or few customers
A company may be doing well and growing at a steady rate. But what if the company has only one customer? What happens if that customer leaves or goes bankrupt? Having a business depending on just a few customers is a sign of poor long-term business strategy and needs to be taken seriously while analysing a company.
Next we will look at the good signs that indicate healthier long-term prospects for the firm.