How to Spot a Dangerous Stock
Contents
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INTRO
Revenue growth in isolation means nothing. Yet, it’s often the primary metric new investors focus on, and that’s a huge mistake. Don’t feel too badly, though. Even professional investors and the Market as a whole tends to place far too much focus on revenue growth alone.
Have you ever witnessed the Market push up the stock price of a growth stock based on its revenue growth alone? Oftentimes, these companies have yet to even prove they can turn a profit.
Or have you purchased a growth stock only to see it plummet by over 50% shortly after? I bet you were caught off guard by those revenue figures and the growth in revenue being incurred without closely examining other key financial aspects.
That ends today. I’m going to show you exactly how to identify these risky stocks, so you won’t fall for it again.
Why Everyone Loves Revenue Growth
If you had a lemonade stand, you’d likely love to see a long line of paying customers, each eager to buy that $1 sip of freshness.
Then, imagine the price of lemons skyrockets, and you find yourself needing exactly $1 worth of lemons for every drink. So, you’re paying $1 to earn $1 at your current pricing levels. At this point, you might think your lemonade stand is headed for trouble if you cannot raise your prices.
Now, let’s take it a step further. Summer arrives, and your line of customers doubles, leading to spectacular growth and tripling your revenue. This is where growth investors get excited.
If you had a lemonade stand, you’d likely love to see a long line of paying customers, each eager to buy that $1 sip of freshness.
Then, imagine the price of lemons skyrockets, and you find yourself needing exactly $1 worth of lemons for every drink. So, you’re paying $1 to earn $1 at your current pricing levels. At this point, you might think your lemonade stand is headed for trouble if you cannot raise your prices.
Now, let’s take it a step further. Summer arrives, and your line of customers doubles, leading to spectacular growth and tripling your revenue. This is where growth investors get excited.
But here’s the catch: your costs have tripled as well. So, despite the booming sales, you’re not pocketing any profit. Eventually, your investor—who provided the cash for your lemonade stand—will lose faith and walk away.
This is exactly what happens to over 90% of growth stocks. Yet, many new investors fall for the shiny allure of future profitability, which rarely materializes. Now that we understand this logic, let’s look at how to easily spot these “turds disguised as raisins.”
An Easy Way to Spot Danger
Any Lord of the Rings fans here? You know, the whole “one ring to rule them all” concept? Well, there’s also a “one ratio to rule them all” in the investing world: Return on Invested Capital (ROIC).
This metric is far more important than just looking at revenue growth. Understanding ROIC gives you a clearer picture of how effectively a company is using its capital to generate profits, making it a much more reliable indicator of long-term success.
Let’s go a bit deeper.
Return on Invested Capital (ROIC) is a key financial metric that measures how effectively a company uses its capital to generate profits. The formula for ROIC is:
ROIC = (Net Income - Dividends) / Invested Capital
For example, if a company has a net income of $1 million, pays $200,000 in dividends, and has $5 million in invested capital, the ROIC would be:
ROIC = (1,000,000 - 200,000) / 5,000,000 = 0.16 or 16%
In super simple terms, ROIC tells you how well a company is using its money to make more money.
A good ROIC typically varies by industry, but as a general rule of thumb:
- Above 10%: This is often considered a solid benchmark for most companies. It indicates that the company is effectively generating profit from its invested capital.
- 15% or higher: This is generally seen as a strong ROIC, suggesting that the company has a competitive advantage and is effectively using its capital to generate returns.
- 20% or higher: Companies with this level of ROIC are usually viewed as exceptional performers, often indicating a strong market position or a unique business model.
If a company’s ROIC is strong, growing sales likely mean more profits. If it's below average, growth could actually detract from value. Now that we have our theory in order. Let’s look at the perfect example.
A Dangerous Stock - Case Study
Never chase the hype that tends to be ever-present in the stock market. Don’t let yourself get blindsided by revenue growth.
Take Rivian, for example—they saw their revenue grow by an impressive 166.87% in a year. That’s remarkable, right?
But here’s the catch: their ROIC is negative, meaning that for every dollar invested in the company, it’s creating less than one dollar in market value. As a result, the stock price inevitably followed suit—after the initial hype wore off, of course.
Always remember to look beyond the flashy numbers and focus on the underlying fundamentals. Conducting a little bit of due diligence in the form of some basic research and analysis can go along way toward providing you with excellent investment returns.
Conclusion
If you’re looking for one core takeaway from this article, it’s this:
Focus on profitability, and one of the very best metrics to provide insight on this is ROIC. Don’t just look at revenue growth alone. The ability of a company to turn those sales into real profit provides an accurate picture of its longevity in business…and, in turn, its ability to provide you as an investor with a high ROI.
Growth in sales, earnings and assets can either add to or detract from an investment's value....depends whether ROIC is above average, thereby reflecting that every dollar being invested in the company is creating at least one dollar of market value.
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