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Don’t buy that stock! 5 alarm signals investors must heed

You should always carry out due diligence before investing in a stock, otherwise you could be in for a nasty shock. Here are five red flags of which to beware.

Debt is rising

Once debt runs out of control, a company is in trouble. Ultimately, it was debt that did for Thomas Cook, after 178 years. The group almost went bust in 2011, after its 2007 merger with MyTravel ended in a £1.1bn write-off, and it couldn’t shake off its problems.

High debt levels leave a company vulnerable to one poor year of trading. For example, Thomas Cook was hit by Brexit, sterling weakness and the 2018 heatwave, which combined to cut bookings. This left it requesting a £250m bailout that never came.

So if tempted by a stock – particularly one trading at a bargain valuation – always remember that debt is a four-letter word.

Earnings are slowing

One figure I always look for is earnings per share (EPS) growth. You can find this figure fairly easily on many stock market websites, often going back five years. The trend is nearly always interesting.

Take BT Group. In the year to 31 March 2015, it posted EPS growth of 12%. Next year, that fell to 1%, a bright red warning flag. The following three years EPS were all negative, down 9%, 3% and 6%, and there’s another 10% drop forecast in the year to 31 March 2020. The BT share price has plunged.

Earnings trends can also point to growth. City analysts reckon BT may finally reverse the negative trend in 2021, which is one reason I said the falling knife may finally be worth catching.

The P/E ratio is out of sync

I also look out for the price/earnings ratio indicating how highly investors value a stock. Like any number, you should never just look at it in isolation, but should also compare it against other companies in the same sector.

If it’s a lot more expensive than its rivals, there has to be a good reason why.

Directors are selling

If a company’s directors are rushing to sell off their stock, should you really be rushing to buy it?

Russian steelmaker Evraz has looked temptingly cheap lately, trading as low as four times earnings, while yielding upwards of 15%. However in June, three directors and non-executive directors all sold part of their stakes for over £86m, with little explanation, while chairman Alexander Abramov sold more than £50m in March

Directors may have a valid reason, anything from tax planning to buying a new yacht, but it’s a worry if those at the top are bailing out.

The dividend is dizzying

A sky-high yield can also be a warning sign. The yield is calculated by dividing the dividend by the share price, so if the payout is 5p and the stock trades at £1, the yield is 5%. If the company issues a shock profit warning and its share price collapses to 50p, the yield is then a juicy 10%.

In this case, a high yield is a sign of trouble. It may not be sustainable either, and a cut will inflict further damage on the share price. British Gas owner Centrica‘s 15.9% yield is hardly evidence of a thriving company.

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Harvey Jones has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.