New investors, check on debt, dividends
Question: After years of investing in mutual funds, I’m finally going to start buying individual stocks. What are some red flags that would suggest a stock is a bad investment?
Answer: While there are few 100% accurate indicators that a stock is a bad investment, there are some things beginning investors should generally stay away from.
First, be wary of any stocks whose dividend yield looks too good to be true. For example, if most stocks in an industry pay 3% to 4% dividend yields, a stock in the same industry that pays 8% might be a dividend yield trap.
Similarly, avoid stocks that have cut their dividends in the past few years. Generally speaking, this is a sign of instability in a company.
It’s also a smart idea to stay away from stocks trading for less than $5. Not all low-priced stocks are trouble, but this area certainly tends to have more scams and distressed companies.
Steer clear of companies with lots of debt. The definition of an appropriate debt level is industry-specific, so comparing debt metrics such as a company’s debt-to-equity ratio with others in its industry can help you identify these.
Finally, avoid investing in companies with falling revenue, unless there’s a good reason for it.
If sales are falling, it can be an indicator of serious problems with a company’s business model or with the entire industry (think department stores such as Sears or J.C. Penney).