11 Red Flags I Look For In Every Public Company
How to Spot Them Before It's Too Late
Spotting red flags in public companies can save you from costly mistakes.
After analyzing hundreds of public companies, I’ve noticed common warning signs that often signal trouble ahead.
Here is my list of 11 red flags and how you can identify them:
Big mergers & acquisitions
Frequent management changes
Frequent reorganizations
No pricing power
Shrinking revenue and losing market share
High debt levels
Poor capital allocation
Use of company-defined, adjusted, or non-GAAP metrics and ratios
Poor cash-flow (vs. good P&L)
A lot of related-party transactions
Too much dependence on a few customers or products
1.0 Big Mergers & Acquisitions
Many CEOs have big egos and want to be remembered for something they’ve done. Being in charge of a major merger or acquisition is definitely up there on the list.
Unfortunately, studies show that this is the quickest way to destroy shareholders’ value.
The explanation is fairly simple: Storytelling and exaggerating “synergies” can justify the price paid for a company.
When the story falls apart, it results in goodwill impairment. Be careful with companies that have a long history of acquisitions, and almost equally long history with goodwill impairment. They’re likely to continue down that path.
2.0 Frequent Management Changes
Stable and effective leadership is vital for long-term business success.
The top management of each company (most often) has a long-term vision about the company and a plan for how to get there. Therefore, a CEO/CFO change has a ripple effect on all the other layers.
Don’t get me wrong; a change of this kind isn’t necessarily bad or uncommon, and there could be many reasons for it.
But we can all agree that if there are four CEOs/CFOs in two years, chances are something is going on under the hood.
If this is coupled with frequent auditor changes, especially if the new auditor is not one of the Big Four, the red flag becomes more prominent.
You are one Google Search away from finding out if this is applicable to the company you are analyzing. Note: Don’t limit your scope to the CEO/CFO. Expand it to all key personnel. It could be the CTO, board of directors, the presidents of the key divisions, etc. It would take less than 15 minutes of your time to spot a red flag of this kind.
3.0 Frequent Reorganizations
How would you feel if you had three different managers in the last year and some of your colleagues were laid off? Probably a bit uncomfortable and uncertain about the future.
A solid organizational structure is crucial to efficient work. Management sets up divisions, teams, and workflows to execute its vision.
Therefore, a stable organization performs much better than one that constantly changes.
This doesn’t mean no company should undergo reorganization. The environment continuously changes, and reorganization helps companies adapt faster to new market conditions. This allows companies to improve their structure and deliver more value in the future.
I have no problem with this as long as it doesn’t happen frequently and the reorganization's value is clearly communicated internally and externally.
However, if reorganizations occur almost every year, I’m out, regardless of how enthusiastic the CEO might sound during the earnings calls.
Frequent reorganizations consume significant resources, create a negative internal sentiment, and distract employees from doing their best to add value. Their focus will shift to worrying about whether they’ll remain employed after whatever comes next.
The easiest way to check for this red flag is to see how often the company has reported a restructuring expense in the profit & loss statement and how significant it is.
4.0 No Pricing Power
A company’s ability to set prices is crucial to healthy margins. Pricing power is necessary to cover costs and fund growth without losing customers.
There are many ways to assess if a company has pricing power, and the most common one is through the gross and operating margin.
Shrinking margins in combination with spending more cash on marketing to maintain the same revenue is not sustainable in the long run.
Many companies have engaged in price wars, lowering prices to remain competitive. The only winners are the final consumers.
In theory, you can automate this check. All you need to do is write a simple formula that looks at the margin of the last few years and compares it with the margins of the last decade. As long as the margin is flat or improving, that’s fine.
However, this approach has many flaws.
If there’s a software company (high-margin) that launches a hardware product (low-margin) and spends money on marketing, it would fit in the description above. But that doesn’t mean the company is failing. In fact, the low-margin product could be a huge success, and it would naturally push the margins down.
The best approach is to understand what causes the increase/decrease in the gross and operating margin. This takes more time, but is crucial for understanding the company. Which brings us to the next red flag.
5.0 Shrinking Revenue and Losing Market Share
Plenty of companies were disrupted, including Nokia, Kodak, Motorola, BlackBerry, and Blockbuster. All experienced shrinking revenue and lost market share.
Sustainable business success has stable or growing revenue and stable or increasing market share.
Economic downturns or industry shifts happen, and they affect all companies. However, if revenue is shrinking while competitors steal their share, that’s a red flag. This signals competitive disadvantages or fundamental flaws in its business model.
A quick approach to assess this is to compare the revenue growth/decline of the company against its competitors. Although this sounds a simple task, there are a few things you need to consider:
Some companies engage in acquisitions. This has an impact on the revenue, and it could hide the poor performance of the business prior to the acquisition. Make sure you’re comparing organic growth/decline of the companies.
Some companies have multiple divisions. Make sure you are comparing the right divisions. Otherwise, your comparison would be apples to oranges, leading to incorrect conclusions.
6.0 High debt levels
Debt can fuel growth when managed well.
However, if it spirals out of control, it becomes a huge problem. That problem only grows when interest rates rise, as eventually, the loan will be refinanced, pushing the interest expense up.
Many metrics already exist:
Net debt to EBITDA ratio
Interest coverage ratio (EBIT / Interest expense)
I prefer the second one, but I do make an adjustment myself. If the debt comes with fixed interest rate, the interest rates have been increasing, and the debt is due for renewal in the next few years, I use what I expect to be the new interest expense. In theory, this ratio should be above two. Of course, the higher, the better.
If a company’s coverage ratio is below an acceptable ratio and is continuously deteriorating year after year, that is definitely a red flag.
7.0 Poor capital allocation
Smart capital allocation drives value. Poor capital allocation destroys value. Here are some examples:
Buying back shares at prices above fair value;
Keeping too much excess cash on the balance sheet for many years, especially if the interest rates are low;
Raising more debt (when the debt is already too high) to pay dividends;
Engage in M&A projects that lead to impairments;
You can take a look at the capital allocation decisions if you take the cash flow statements of multiple years. Each of the three sections is valuable, and you can see where the cash is coming from and going to.
The longer timeframe you have (a decade, for example), the better you can understand the past capital allocation decisions.
8.0 Use of company-defined, adjusted, or non-GAAP metrics and ratios
The majority of CEOs are storytellers, which means they’ll come up with ratios and metrics that sound good. This doesn’t mean the metrics and ratios are incorrect, but they’re defined in a way that serves them. The more attention is given to these metrics, the more there is to hide.
WeWork had a metric called “Community Adjusted EBITDA”. In 2018, WSJ reported that the company had revenues of $866 million, with losses of $933 million. The community-adjusted EBITDA was $233 million.
How?
Well, it starts with the net profit. The interest, tax, depreciation, and amortization were added back, as well as many basic expenses like marketing, general and administrative, and development and design costs. The company filed for bankruptcy protection in November 2023.
If most of the attention goes towards company-defined, adjusted or non-GAAP metrics, be careful.
9.0 Poor Cash Flow (vs. good P&L)
If the company’s underlying profitability differs from the cash it generates, there are likely some accounting shenanigans.
I’d like to walk you through one simple example that is present in many public companies:
Let’s assume a company is reselling chairs, and its annual demand is 700 chairs.
Each chair is being purchased for $50 and sold for $80. So, in a full year:
Revenue: $56,000 (700 chairs x $80)
Direct costs: $35,000 (700 chairs x $50)
Gross profit: $21,000 (gross margin of 37.5%)
Now, the supplier has a special offer. If you buy 1,000 chairs, the price per chair will be $40! What’s the catch? It’s a 3-year contract, with 1,000 chairs per year.
Let’s take a look at the profitability in this case:
Revenue: $56,000 (700 chairs x $80)
Direct costs: $28,000 (700 chairs x $40)
Gross profit: $28,000 (gross margin of 50%)
Unfortunately, despite the higher realized gross margin, the company is stuck with 300 products for which it paid $40. That $12,000 (300 products x $40) will eventually be impaired as there is no demand. So, although the company is reporting $28,000 in gross profit, the cash generated over this period is $16,000 ($28,000 - $12,000).
Many companies produce more inventory than they can sell. This leads to lower cost per product, which, as pointed out above, translates to higher margins.
Although this might be obvious, management that follows this path will have a good story. The excess inventory will accumulate for a while, allowing the company to report the overstated 50% margin. Then, there will be a “one-time impairment,” which will be disclosed as such.
In addition, “adjusted” metrics would be presented where this one-time impairment is excluded. This is an example of when the profitability doesn’t add up compared to the cash flow.
So, how to deal with this? Analyze the important working capital items on the balance sheet (accounts receivable, inventory, accounts payable). There are many ratios that are derived in relation to the revenue or the cost of goods sold, that help in identifying a red flag of this kind. Be careful with certain companies that are seasonal in nature.
10.0 A Lot of Related-Party Transactions
Related-party transactions occur when a company does business with entities controlled by its executives, major shareholders, or their families.
Transactions of this kind can create conflicts of interest, raising concerns about corporate governance that eventually harm the shareholders.
A one-off related-party deal might be harmless. Family-run companies often sell to subsidiaries or lease from a cousin’s firm.
Ensure that the cash isn’t funneled outside of the business through an overpriced contract or a loan that will never be repaid.
A separate part of the annual report is dedicated to this. It is one of the notes to the financial statements labeled as “Related-Party Transasctions”. This allows you to understand who is involved, the amounts, and terms. With multiple annual reports, you can understand the dynamic behind the related-party transactions and see if these are frequent and odd deals, or not.
11.0 Too Much Dependence on a Few Customers or Products
Businesses overly dependent on a few customers or a limited product line face significant risks. Losing a major customer or experiencing product disruptions can be devastating.
The same logic can be used to determine whether there is too much geographical exposure to a specific country. Especially if that country with high exposure is an underdeveloped (or shady) one.
All of this is also available in the annual reports. Companies provide split of revenue (sometimes it is per product, or product line/division), there’s a geographical split of revenue (by region or country) and a disclosure for all the customers that contribute above 10% of the revenue.
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I agree with all the points. However, 11. in the case of microcaps it's not a "red flag" per se though. I think more about this like a risk rather than a red flag.