All stock investments are inherently risky. Buying a stock makes you an owner of that business, meaning that you are first in line to lose money if something goes awry. The upside is that, as an owner, you get to participate in the upside if things go well. So, making sure that the risk/reward trade-off is fair is a key component of any investment decision. But how exactly should an investor think about the risk of a stock?
At Morningstar we try to look not just at the risk of a firm going belly up but also at how uncertain a company's future is. Practically speaking, that means we spend a lot of time thinking about the range of possible outcomes for the companies that we cover.
Although it's easy to think about the future in a linear fashion, in reality events rarely play out in such a neat and orderly manner. Major structural changes in an industry or a company are inherently hard to predict, but thinking about the future probabilistically allows us to at least open our minds to the possibility of outcomes that, though unlikely, can have a huge impact on a company's value.
This thinking gets distilled into the fair value uncertainty rating that accompanies every stock we cover. There are four steps our analysts take to reach this rating, and walking through these steps can help you assess some of the risks of investing in a particular stock.
The first step is thinking about the likely range of sales for a company. Some businesses--such as supermarkets or consumer product companies--have fairly predictable sales, while many others have revenue lines that can swing around quite a bit.
The second closely related step is thinking about a company's operating leverage. What percentage of each incremental pound of sales becomes income? The key to this question will be a company's mix of variable relative to fixed costs.
These first two questions are going to be answered by reading through the firm's annual reports, looking at the firm's past performance through the economic cycle, and using your own subjective judgment of how successful the firm's products could be over time.
In the third step, you'll take a look at financial leverage because even a steady business can have an uncertain future for shareholders if it has too much debt. Bondholders always get their money first, after all, and financial leverage can amplify equity returns in both directions.
Generally, the more debt a company has, the riskier its stock is, since debtholders have first claim to a company's assets. This is important because, in extreme cases, if a company becomes bankrupt, there may be nothing left over for its stockholders after the company has satisfied its debtholders. Leverage can be measured through several ratios.
Debt/Equity. The debt/equity ratio measures how much of the company is financed by its debtholders compared with its owners. A company with a ton of debt will have a very high debt/equity ratio, while one with little debt will have a low debt/equity ratio. Assuming everything else is identical, companies with lower debt/equity ratios are less risky than those with higher such ratios.
Debt/Equity = (Short-Term Debt + Long-Term Debt) / Total Equity
Interest Coverage. If a company borrows money in the form of debt, it most likely incurs interest charges on it. (Money isn't free, after all!) The interest coverage ratio measures a company's ability to meet its interest obligations with income earned from the firm's primary source of business. Again, higher interest coverage ratios are typically better, and interest coverage close to or less than one means the company has some serious difficulty paying its interest.
Interest Coverage = (Operating Income) / (Interest Expense)
You may also want to think about a firm's liquidity position. In a nutshell, a company's liquidity is its ability to meet its near-term obligations, and it is a major measure of financial health.
Current ratio. The current ratio is the most basic liquidity test. It signifies a company's ability to meet its short-term liabilities with its short-term assets. A current ratio greater than or equal to one indicates that current assets should be able to satisfy near-term obligations. A current ratio of less than one may mean the firm has liquidity issues.
Current Ratio = (Current Assets) / Current Liabilities
Quick Ratio. The quick ratio is a tougher test of liquidity than the current ratio. It eliminates certain current assets such as inventory and prepaid expenses that may be more difficult to convert to cash. Like the current ratio, having a quick ratio above one means a company should have little problem with liquidity. The higher the ratio, the more liquid it is, and the better able the company will be to ride out any downturn in its business.
Quick Ratio = (Cash + Accounts Receivable + Short-Term or Marketable Securities) / (Current Liabilities)
Cash Ratio. The cash ratio is the most conservative liquidity ratio of all. It only measures the ability of a firm's cash, along with investments that are easily converted into cash, to pay its short-term obligations. Along with the quick ratio, a higher cash ratio generally means the company is in better financial shape.
Cash Ratio = (Cash + Short-Term or Marketable Securities) / (Current Liabilities)
And finally, you'll need to consider whether a specific event in the future, such as a product approval or legal decision, could radically change a company's value. This is a good wild card category for thinking about unlikely events that could have a big impact on your investment. For example, investors in banks right now have to weigh how any new banking regulations are going to impact earnings and the sustainability of current business models.
It is impossible to predict every possible outcome and risk for a company. Of course there are going to be events, challenges, and opportunities that no one imagined before they popped up. But by imagining scenarios in which the company will be stressed, you can help yourself better understand the potential risks of investing.
