There are many aspects one should consider when choosing which stocks to buy. Some of those aspects are big picture things, like the economy, segment and politics. Others are very specific metrics such as EBITDA, P/E, EPS, ROE and CAGR. Regardless of which aspects you are considering, it’s important to look at them from a risk perspective.

You can see a company with solid numbers, but that is vulnerable and can be hugely impacted by a change in government regulations. You can also see a growing company in a promising industry but with a weak balance sheet.

Here I share with you four factors to consider risk when choosing stocks. Of course these are not the only factors to consider, and as always, I recommend speaking to a financial adviser before making investment decisions.

What industry is the company in? Is the industry growing? One example I like to give is the tobacco industry, which seems to be losing market over the years. It is also not a product that promotes health, so perhaps as people become more health conscious and stronger regulations are put in place, the risk increases to the investor.

Another example is if the company strongly relies on a single market (like a local business concentrated in one city), single customer (like a power company that has one main factory as its customer) or offers a seasonal product.

The company’s report will give you insights into the industry and the strategies the company is pursuing. However, when analysing risk you need to go beyond that and do your own research as well. Often at the end of the day there won’t be a right or wrong answer, but only one that you feel comfortable with.

Here I’m referring to low volatility in revenue and profit. Has the revenue been solid and steadily increasing over the years? If a company has had many ups and downs in its revenue investigate why that is. What is impacting the revenue? Is it poor management, or other factors impacting the industry as a whole?

How about the profitability? Has it been solid and steadily increasing over the years? What factors have been impacting the profitability of a company?

The balance sheet of a company will tell you the company’s assets and liabilities. A strong balance sheet will show you that the company’s assets are higher than its liabilities. A weak balance sheet will have higher liabilities than assets, and therefore means that the company carries more risk for the investor.

I like to see a company’s assets be 50% higher than a company’s liabilities. Other investors like to see at least that the net debt is less than net assets (net debt/ net assets = less than 100%). There could be exceptions to this, depending on the strategy of the company. Again, at the end of the day there is no right or wrong answer, only what you feel comfortable investing in.

Also related to a solid balance sheet, consider how much net debt a company has. A rule that many investors go by is that net debt should be less than 3x EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).  Even if a company has more assets than liabilities, you want to make sure it can pay its debts from the cashflow generated from its regular activity. 

Another aspect to consider is if the debt has been stable over the years. Is it increasing? By how much and why? It might mean more risk for an investor if a company is unable to operate without increasing its debt.

I hope you found these ideas helpful. What else do you consider when thinking about risk? Let me know in the comments.

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