In each trading day, billions of shares are being traded on stock exchanges around the world. With screens flickering at the tick of every price change, market participants actively buy and sell shares in a bid to make a profit. Traders would think about risks associated with macroeconomic and geopolitical news events that may change share prices in the short-term.
However, if you’re an investor with the resolve to ride out short to medium-term volatility, then you should be concerned about a different set of risks. A long-term investor who buys a company without doing sufficient due diligence is doing himself a huge disservice. The risk often neglected by most retail investors is the possibility of liquidation. A retail investor I once met told me “It’s a bull market, what are the chances of a big listed company going bankrupt? Just buy, save the need for analysis”. A bold assumption like this could be a costly and regretful one.
Well, if you haven’t already realized, there are well-established F&B and clothing stores with very beautiful decor and attractive people working in them that run on pre-tax profit margins as low as 5%. So a little bit more analysis, beyond what looks good on the outside is also recommended, especially when it’s your hard-earned money at stake.
But let’s just say that liquidation is an inherent risk in any share investment. In the unfortunate event of liquidation, WHO’S GOT YOUR MONEY?
*cue sombre music in background*
You, as a shareholder of common shares, will be paid LAST! Yes, to put it nicely, common shareholders have residual claim over the assets of the company during liquidation. To put it bluntly, if you’re a common shareholder, you’ll be left with the crumbs which wouldn’t be much in most cases. So who gets paid first?
There is a hierarchy of claims during liquidation. Creditors, person(s) to which the company its financially obligated to, will have priority over the company’s assets first. Following after, preference shareholders will have priority claim over the assets. While preference shareholders do not have voting rights unlike common shareholders, they have dibs (keeping up with millennial lingo) on dividends declared as well as claims over assets before common shareholders.
And yes, finally we the common shareholders who’ve religiously attended every AGM and believed the beautiful growth story with absolute conviction will now have claims over the remaining assets, if any.
Keeping in mind that we will be THE LAST PERSON to get our money back if the company we invest in goes into liquidation, it is imperative that we carry out sufficient due diligence to mitigate the potential risk of buying a company has a high probability of defaulting on its financial obligations. (Hint: Anyone who at least analysed the debt-to-equity ratio of Lehman Brothers’ wouldn’t have bought it and held it to its imminent demise).
If you’re serious about stock valuation, a must read would be The Intelligent Investor by Benjamin Graham. Of course catch up on our previous company analyses articles as well!
There are a multitude of ways to analyse a company and we have written several articles which you can check out!
- CapitalistLAD Guide to Ratios: P/B Ratio (Part 1)
- CapitalistLAD Guide to Ratios: P/B Ratio (Part 2)
- CapitalistLAD Guide to Ratios: P/S Ratio
- Cigar Butt Investing Decoded
- Investing in Companies with Economic Moats can give you an Edge
- CapitalistLAD Guide to Share Dilution
- Invest using SWOT and Porter’s 5 Forces
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Till next week, have a good weekend!