The Motley Fool

How to avoid dud stocks

There have been a number of shares on the ASX that have fallen significantly in recent times. For example, the Big Un Ltd (ASX: BIG) share price had dropped from $4.79 to $2.22 before being suspended in February and it has remained that way ever since.

GetSwift Ltd (ASX: GSW) is another, the share price fell from $4.30 to $0.41 today.

Growth stories make for the most exciting shares on the ASX. However, the story has to be backed up by results.

I think we are coming to near the end of the bull market when many people are trying to justify valuations based on future revenue multiples and not necessarily profit, cashflow or the balance sheet.

One of the main ways that I now try to avoid dud stocks is by first seeing the business is actually growing its revenue and operating cash. If revenue is not translating into the form of cashflow growth then I am much more sceptical.

Another way I’m being careful is by waiting to see if exciting news turns into exciting results. There’s nothing wrong with being a year or two late into a genuine 10 year growth story like a2 Milk Company Ltd (ASX: A2M), but things can go bad if you’re six months early into a growth stock which doesn’t turn out.

The best way to avoid dud stocks is to only invest in shares that are already making a profit and have an expectation of growing revenue and profit into the future. It is much easier to value a company when you can look at its current price/earnings ratio and its predicted future earnings growth. A stock can grow into its valuation if it continually grows profit.

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Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of A2 Milk. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.