How to Determine the Downside Risk of a Stock

Updated: October 25, 2023


In this article, I will show you how to determine the downside risk of a stock investment. Downside risk is the worst-case scenario for a stock. It represents what could happen to a company's stock price if it does not perform up to investor expectations. Therefore, knowing how to determine the downside risk of a stock can provide investors valuable information on the potential losses one could experience from an investment, and how to best protect against it over the long-term.

Importance of Downside Risk

Although rather straightforward, investors should take into consideration BOTH the upside and downside risk of investing in a stock, regardless of how "safe" the investment may be. If you do not, then you're going to consistently lose money in the stock market. The following two sections expand upon this and explain why estimating the downside risk is important for investors, besides the obvious.

Field of Possibilities

Investors should be aware that every investment has a field of possibilities, all of which could happen, but each of which has a different probability of occurring. For instance, a stock may have a 20% chance of going up at a rate of 10%, but it also might have a 20% chance of going bankrupt.

Unfortunately, many investors tend to ignore the downside risk of a stock and only focus on the potential gain they expect from an investment. This is extremely irresponsible for long-term investing in particular, where stock prices can fluctuate greatly.

In short, anyone can make an upside case for almost any stock in the stock market. For example, you could make a case that a stock will rise 10x over the next 5 years. However, the probability of this happening may be very low, and the company going bankrupt may be even more likely than this, which could lead to you losing most, if not all of your money.

Reduce Confirmation Bias

Investors should invest in stocks objectively and should avoid making emotion-based investment decisions. However difficult it may be to avoid bias and market noise, investors should look objectively at what's happening within a business before making an investment decision and/or deciding on a buy-price for a business.

Confirmation bias is when you are subconsciously seeking out information on a company to support your opinions. For instance, when attempting to research a company further, you may look up articles or read pieces from analysts on how the company is expected to perform. Subconsciously, you will click on articles that will favor your opinion of the stock price performing well in the future and you will avoid or ignore the articles that make compelling cases on why the stock price may fall over the long-term.

This can also apply to any company filings, such as the 10-K annual report, and how investors can fail to look further into certain topics discussed in the "management's discussion and analysis" (MD&A) section, for example.

The point here, is that by estimating the downside risk of your holdings, it's likely that you will reduce your confirmation bias as you'll actively be looking for factors that could affect the downside risk of your stock investment. After all, if you see that a company is over-levered with debt, you may begin to interpret the company's potential upside in a different way.

How to Estimate the Downside Risk of Your Holdings

To determine the downside risk of your stock market holdings, you can use the following list below. This list will not tell you how a stock will perform moving forward or in a recession. This is impossible to predict as there are a lot of unknowns and company, industry, and/or event-specific details that can influence a company's stock price, which we simply cannot account for in our analysis.

Instead, this list will help you gauge the risk of your holdings through looking at past performance and company financial data. It will therefore help you identify any holdings that are highly susceptible to downturns (aka red flags) so that you can adjust your portfolio to your desired risk tolerance level. If a majority of your investment money is tied up in stocks with a higher downside risk, you can consider diversifying your holdings more.

Understanding where your portfolio or company falls on the list below will give you more peace of mind during recessions and through market volatility in general. After all, if you understand the downside risks of an investment, it's a lot easier to stand by them when they fall in price.

Factor #1: Business Life Cycle of a Company

The business life cycle of a company refers to the progression of a business over time. As illustrated below, it's typically divided into four stages: introduction, growth, maturity, and decline:

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StableBread: Business Life Cycle Stages

Investors should determine what stage the company they're analyzing falls in, as it can provide a lot of insight on the downside risk of the company. Generally speaking, companies in the introduction, growth, and decline stage have more downside risk than companies in the maturity stage.

Companies that are experiencing high growth are often startup, small-cap companies, or companies who recently had their initial public offering (IPO) in the stock market. These companies have a higher downside risk as they have little to no financial data of which investors can use to analyze the expected growth of the business or to accurately predict future cash flows.

Typically, these high growth companies have a high P/E ratio, which means that the stock price is high relative to earnings and potentially overvalued.

P/E ratio = Stock price / Earnings per share (EPS)

High growth companies tend to have a high P/E ratio because investors expect their earnings to go up massively in the future. The problem here, is that if the company misses these expectations, even slightly, the stock price and P/E ratio can come down significantly rather quickly.

Therefore, if you're investing in a company with a high P/E ratio and investors have high expectations for growth, then keep in mind your investment returns are very susceptible to whether the company can beat these expectations regularly. If not, it's very likely that your downside risk and probability of downside will be substantial.

If you have a long-term investment horizon and/or are more risk-averse, then you should stick with investing in companies that are older and more established. These companies have relatively stable earnings and consistent growth that is generally predictable. Moreover, these companies also likely have a strong economic moat built up and are therefore a lot less likely to lose you money over the long-term. In addition, these companies will have significantly less downside risk than recently IPO'd companies or high-growth companies.

Factor #2: Company Profitability

The second factor you should look at is how profitable a company is. In theory, a company's stock price is dependent on how profitable a company is or how profitable it's expected to be. Therefore, profitability is one of the first things you should look at when determining the downside risk of your holdings.

Tying into the previous section, when companies are in the high-growth stage, they are usually spending more than they make upfront to expand production or to grow their customer base through an aggressive marketing budget.

Often times, these companies are not generating a profit, breaking even, or making very little in net profit. This funding is therefore heavily reliant on equity and debt, which is relatively easy to come by during good economic times. The problem here is when fears of a recession grow, stock prices tend to fall more drastically as the market is less forgiving of loss-generating companies. Investors then become less willing to fund these early-stage companies, which puts these companies at risk of losing money. Companies with high levels of debt are especially vulnerable during recessions as well, as later discussed.

In short, it's worth looking at whether a company is profitable or not to determine its downside risk. Obviously, a company that is not profitable will have much higher downside risk than a company that has enough cash to pay dividends, for example.

To better understand a company's net profit (aka net earnings), investors can look at a company's margins. The bigger the margin, the better. Different industries also use different measures of profitability when analyzing a company's margins, so keep this in mind. The standard one, however, is the net profit margin:

Net profit margin = Net income / Revenue

To determine whether a company's net profit margin is "good", it can be compared to competitors in its industry.

You can also look at the cash flows of a company, found in the statement of cash flows in the company's 10-K annual reports, to ensure the company has enough cash to continue sustaining itself. Clearly, companies with a substantial and growing cash balance will have a much lower downside risk than those without. After all, its the company's cash balance that keeps debt collectors away, not the value of the assets on their balance sheet or potentially manipulated revenue and net income figures.

Factor #3: Liquidity and Access to Capital

Liquidity is the amount of money a company can quickly access, much like money in your bank or emergency fund. This includes cash balances and short-term investments, found in the current assets portion on the balance sheet.

To gauge liquidity, you can use ratios like the current ratio, quick ratio, or cash ratio. These ratios are all similar, but differ in how strict of a definition they place on liquidity. You should compare each metric to peers in its industry as well as historical values to understand where the company stands.

The current ratio roughly shows whether a company can meet its short-term obligations (over the next 12 months).

Current ratio = Current assets / Current liabilities

The quick ratio also shows whether a company can meet its short-term obligations, but excludes inventory from the calculation as it can be harder to liquidate in a downturn. It's therefore a more conservative ratio than the current ratio.

Quick ratio = (Current assets - Inventory) / Current liabilities

The cash ratio only compares current liabilities to cash and cash equivalents the company has on hand. The cash ratio is therefore the most conservative liquidity ratio to consider here, as it ignores all other current assets.

Cash ratio = Cash and cash equivalents / Current liabilities

Access to Capital

Access to capital refers to the amount of money a company can quickly access from banks. In a company's regulatory filings, you can find disclosures about unused or available lines of credit or revolving credit facilities.

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Home Depot (HD): Discussing its Access to Capital

This refers to money they've been pre-approved to borrow and spend. If these companies face a temporary drop in cash flows, it can help them close the gap and continue their operations until things recover and they are able to grow their operations again.

Factor #4: Debt

Debt is very useful to companies as it can be used to leverage their growth and boost profits. However, companies that are over-levered, meaning they have too much debt, can increase the risk of the company going under and filing for bankruptcy. On the other hand, companies with little to no debt have more flexibility with running their business, have essentially eliminated the risk of defaulting on their debt, and have confidence in the revenue their business can generate.

In general, the more debt a company has, the more interest payments are burdening the company. These levered companies have interest payments they need to meet, and if they miss one of these payments, there are severe consequences for the company.

Two of the most common actions companies take after missing an interest payment are described below:

  • Filing for bankruptcy protection: From an investor's perspective, once a company files for bankruptcy protection, this typically means a plummeting stock price and a huge return on investment loss.
  • Make bondholder agreements: Creditors have the right to demand the company to liquidate its assets, so that they can recover their principle from the proceeds. Common shareholders are last in line when this happens, so there's usually not much left for them to recover afterwards.

Obviously, companies that are at risk of missing interest payments have a huge downside risk. It's also important to note that lower interest rates make debt more affordable to companies. This encourages companies to take on more debt than necessary, which can make companies vulnerable to rising interest rates and any unforeseeable events.

Now, if companies don't have any debt, they can't go bankrupt, even if they're unprofitable. Companies that have little to no debt are also not weighed down or worried about any future debt payments that need to be paid down. Instead, they are focused on growing the business.

If you invest in companies with no debt, your return on investment will be almost entirely dependent on the profitability of the company. However, you'd also completely eliminate the downside risk of the company going bankrupt because of mismanaged debt.

You should therefore assess whether a company's debt is manageable or not. This includes determining whether the company can generate enough free cash flow in order to pay off any future debt payments. Typically, companies that have high or unmanageable amounts of debt have a higher downside risk. Therefore, if you have a long-term perspective on investing or want to reduce your downside risk, then look for companies that can manage their debt or those with no debt whatsoever.

To quickly analyze a company's debt position and its potential downside risk, you can look at three main items below. For a more in-depth analysis, see the article linked above.

Debt Balance

A company's debt balance is the total amount of money it owes to creditors. To gauge how much a company has borrowed, you can look at this number as a whole (short-term debt + long-term debt), but it's more useful to look at the following leverage ratios instead.

The first is the total-debt-to-total-assets (TD/TA) ratio, which shows the total amount of debt relative to assets owned by a company. The higher the ratio, the more levered and risky company is to invest in, as more of its assets would be financed by creditors.

TD/TA ratio = Total debt / Total assets

The next ratio is the net debt-to-EBITDA ratio, which shows how many years it would take for a company to pay back its debt, if net debt and EBITDA (earnings before interest, taxes, depreciation, and amortization) are constant. The higher the ratio, the less likely the company is able to handle its debt burden, but this should also be compared to the industry standard.

Net debt-to-EBITDA ratio = (Total debt - Cash and cash equivalents) / EBITDA

Interest Payments and the Interest Rate

The next thing you should look at are the interest payments the company makes on its debt and the respective interest rate. The interest rate is the annual percentage rate on the company's debt balance that is owed to its creditors. On a company's 10-K annual report under the income statement, management will typically disclose this as "interest expense."

The interest rate itself is also sometimes disclosed in the 10-K annual report and is also referred to as the "effective interest rate." However, this is not necessary as we'll be using the interest coverage ratio, which only considers interest expense.

The interest coverage ratio (aka times-interest-earned ratio) is commonly used to determine how well a company can pay the interest on any outstanding debt. This coverage ratio illustrates how many times a company's operating profit (aka EBIT) covers their interest obligations. A higher coverage ratio is ideal, as its debt expenses may not burden the company, but this should be compared to the industry standard as well.

Interest coverage ratio = Earnings before interest and taxes (EBIT) / Interest expense

Financial Covenants

Financial covenants are contracts which require a company to meet certain operating criteria to make the loan safer for the lender. Some examples of financial/debt covenants include, but are not limited to:

  • Interest coverage ratio
  • Debt-to-equity (D/E) ratio
  • Debt-to-total assets ratio
  • Dividend payout ratio
  • Current ratio
  • Net debt-to-EBITDA ratio

Not all financial/debt covenants are based on ratios, as others are based on maintaining a certain cash balance, keeping facilities in good working condition, or maintaining proper insurances. However, this is less common, so we'll focus on financial ratios.

Now, let's say a company makes a financial covenant with a bank that requires it to keep its debt-to-equity (D/E) ratio below 2.0. If earnings were to fall during a recession and the company was forced to take on more debt, this could push the company's D/E ratio to rise above 2.0, which can have a number of consequences.

Typically, these consequences would either be for the company to immediately pay back its debt balance or to begin paying a higher interest rate on the loan(s). As investors, we want to avoid companies that are at risk of breaking their financial covenants, or those that have little wiggle room in meeting these covenant criteria. Doing so can decrease one's downside investment risk.

Financial covenants can be hard to find and/or understand for a company as they're proprietary information between the lender and debtor. However, the "notes to the financial statements" in the 10-K annual reports should, at the very least, mention whether there are any financial covenants and if they are being maintained.

Factor #5: Fixed Costs and Commitments

Fixed costs and commitments are agreements a company must follow through with, much like debt repayments, regardless of the company's financial position. If a company cannot meet its fixed costs and commitments, then it can go out of business.

Examples of fixed costs include amortization, depreciation, insurance, rent, salaries, utilities, leases, and more.

Leases, for example, are agreements companies enter to borrow land, buildings, or equipment from the owner. For example, a company may agree to a 10-year property lease and would have to make monthly rental payments on this property.

Although this can make it easier for companies with fewer assets to run their operations, these payments must be fulfilled or the lessor can demand the property to be returned or even pursue litigation to recover the remaining balance owed on the lease. Companies that are struggling with their debt management may also have problems managing their fixed costs, which naturally leads to more significant downside risk.

You can use the fixed-charge coverage ratio (FCCR) to determine how well a company can cover its fixed expenses, based on a company's earnings:

Fixed-charge coverage ratio = (EBIT + Lease payments) / (Interest payments + Lease payments)

The higher the fixed-charged coverage ratio, the better. You can find the inputs for this formula in an income statement.

"Commitments" refers to any agreement that may not show up explicitly on the financial statements. For example, an airlines company may have a derivative agreement, such as a futures contract, whereby they've agreed to purchase one billion dollars worth of jet fuel next year, even if they don't end up using all of it. Therefore, it's worth looking at a company's commitments (aka contingencies), which should be discussed in the "notes to the financial statements" in the 10-K annual reports.

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Home Depot (HD): Commitments and Contingencies

Margin of Safety for Downside Protection

Besides looking at the five factors above to gauge how much downside risk a stock investment has, investors can also apply an appropriate margin of safety when valuing stocks and determining an intrinsic/fair value buy price range. This is also the most practical approach for long-term value investors who may be holding a stock for 10+ years.

The margin of safety is simply the difference between the intrinsic/fair value of a stock and its market price. In general, this can vary wildly depending on the investment, the investor, and the valuation model. What's important, however, is that you apply a margin of safety to buy companies far below what they're worth, based on your future cash flow projections for a company.

In general, a larger margin of safety is appropriate for companies with a more uncertain valuation, as more downside risk is naturally implied. For example, a 30-50% margin of safety may be appropriate for a company with free cash flows that are difficult to predict, which are typically high-growth and/or less mature companies with a smaller operational history. Although the margin of safety can also vary depending on the discount rate, an appropriate margin of safety can provide significant downside protection.

It's also in good practice to apply an appropriate margin of safety to a varying level of intrinsic/fair values, based on a sensitivity analysis where you may be changing growth and/or the discount rate. For instance, you may have a worst-case, normal-case, and best-case scenario for the intrinsic/fair value stock price of a particular company, which you'd then apply an appropriate margin of safety to.

With this method, you don't have to estimate or worry about how much a company's earnings will go down, as your margin of safety and valuation will essentially "guarantee" limited downside. Even if the company stops growing as rapidly as it once did, you likely won't lose money, but just make a smaller expected return.

In summary, to protect yourself against the downside risk of a stock, apply an appropriate margin of safety to your valuation. The downside is that you will lose a little or break even. The upside, however, can be quite significant.

The Bottom Line

In closing, understanding the downside risk of an investment is extremely important. You cannot just invest in a stock and expect it to always appreciate in price without considering the downside risk of investing in the stock. Regardless of how "safe" your stock investment is, the potential to lose your entire investment is always present with companies in the stock market.

Therefore, to determine the downside risk of a stock investment, make a strong case for it based on the five factors discussed in this article. In other words, look at and analyze where the company is in respect to the business life cycle, company profitability, liquidity and access to capital, debt management, and any fixed costs and commitments. This should provide you with an in-depth understanding on the downside risk of investing in the company.

Afterwards, you can use this information and a near-complete valuation model to apply an appropriate margin of safety to a range of intrinsic/fair value stock prices. In general, the more uncertainty you have with a valuation model, the higher the margin of safety percentage should be. Applying an appropriate margin of safety will therefore protect you from much of the downside risk a stock may experience. More importantly, it will maximize your return on investment over the long-term.

Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance, investment, or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.

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