Out of the asset classes of cash, bonds, property, and equities, the latter is considered the most risky investment. However investors can identify stocks to match their risk profile by evaluating the level of risk by looking at the debt, market cap, profitability, age and sector of that company.
Large company debt
Companies which have large debt numbers on their balance sheet are more risky than companies that have lower debt levels. To calculate the debt ratio you can use the formula of total debts/total assets. A good debt ratio is b 0.4 or lower. Companies which have high debt levels have a higher risk of defaulting on loans. Firms which have high debt levels will also find it harder to obtain further credit. When a company is highly leveraged, they have more debt to service which may mean they are at higher risk of bankruptcy if company revenue declines. Companies that are too leveraged will also find profitability challenging if debt servicing expenses are too high. Shareholders do not receive anything if a company become bankrupt.
When evaluating risk, large cap stocks are the most stable and small cap stocks are the most risky. The problem with small cap stock is that there is not a lot of liquidity in the market. If you have a position in a small cap stock and the share price drops, then it may be hard to find buyers. Shareholders of the stock may need to sell at a lower price to completely liquidate their position. The share price of small cap stocks is more volatile due to this liquidity reason. Buyers and sellers can move the share price through transactions as there might not be a lot of units to buy or sell. As there are more shares on issue with large cap stocks, it will take much larger transactions to move the share price so these prices move less on larger companies.
Profitability of the company
Shareholders may buy a stock for its future potential which means that could be investing in a company which isn’t making any money. They may believe the story and want to invest now in the hope that the company will make in the future. However, these types of companies can become bankrupt and delist from the exchange, leaving shareholders with nothing.
Age of company
As we mentioned earlier, large cap stocks are less risky than smaller cap stocks. Larger cap stocks are usually mature companies which have been around for a while and have proven to be solid revenue earners. Smaller cap stocks are still in the growth phase and still need to establish themselves. However, the potential for growth is higher for smaller cap companies than it is for larger cap companies.
There are some sectors that are riskier than others on the stock exchange. Industries such as energy, commodities and consumer discretionary stocks are more volatile sectors than other more stable industries such as consumer staples and healthcare. Cyclical stocks such as energy, commodities and consumer discretionary stocks do well when the economy is doing well. Stocks such as consumer staples and healthcare are companies which consumers will always need regardless of what is happening with the economy and hence this characteristic makes them more stable in the long run.
Lauren Hua is a private client adviser at Fairmont Equities.
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