Profit warnings can prove disastrous for investors. A company’s share price reflects investors’ collective view of what the business is worth both today and in the future – the revenues and profits it is expected to achieve in the years ahead.

When a company says previous forecasts of profits now look overly optimistic, that market view inevitably changes for the worse – and shares fall accordingly.

Sometimes, those declines can be dramatic. Shares in UK housebuilder Vistry, for example, fell more than 35% last month after it warned that it had underestimated the cost of some key projects – and said the revised math would hit its profits for the next three years.

The share price of luxury carmaker Aston Martin slumped more than 20% in September when it revealed that its profits would be lower than expected for the year. A few weeks before that, pest control business Rentokil saw its shares drop 18% after a similar announcement.

How common are these profit warnings?

Worryingly, companies warn about profits pretty often. In the first half of the year, 119 publicly traded companies issued such an alert in the UK alone, according to data from EY. And that number was actually a little lower than in previous years.

Against this backdrop, it makes sense for investors to monitor their portfolios carefully – to keep an eye out for the early signs that a profit warning might be in the cards. That’s not to say you’d dump your shares if you suspect a warning might be coming – but it might inform your decision about whether to sell, hold, or buy more.

How can you tell if a profit warning is coming?

Folks look for certain red flags that might indicate that a company is about to issue a profit warning. So interactive investor asked a group of professional fund managers which ones they watch for.

Emma Moriarty, portfolio manager, CG Asset Management.

Perhaps counterintuitively, the first places that she and her team look for signs of future weak profitability are the balance sheet and cash flow statement. That’s because they have found that companies these days, particularly those with long-duration assets – such as infrastructure and real estate – don’t have the appropriate balance sheet for a higher-for-longer interest rate environment.

Back when interest rates were low, the impact of financing marginal investments with debt was positive. But that’s no longer the case. So now early warning indicators of potential trouble include floating-rate debt or refinancing risk.

The team also checks out company cash flow statements: firms can turn cash flow negative even if they’re still reporting positive profits. That said, when these pros have a high conviction on a stock, they tend to sell only as a last resort. They’re more likely to hold on for the long term and seek to engage with management and boards to push for change.

Cormac Weldon, co-manager, the Artemis US Smaller Companies Fund.

When Weldon and his team look to buy a company, they consider the upside potential. They also consider the downside potential and the things that could undermine its progress. They’re looking for asymmetry: the places where the upside potential might heavily outweigh the downside risks, or vice versa.

You can’t avoid profit warnings altogether, Weldon says, but with research and skill, you can reduce the chances. Mind you, it’s also essential to monitor progress and whether expectations are being met. Weldon looks closely at the trends – market share growth, profit, and so on. If sales growth is in line with expectations, but margins are becoming squeezed, he’ll take that as a red flag.

Neil Hermon, portfolio manager of the Henderson Smaller Companies Investment Trust.

Hermon keeps an eye on forward-looking economic indicators. But he also looks for increasing accrued income balances on the balance sheet, which may suggest that the company is undertaking aggressive revenue recognition policies as it struggles to meet market forecasts. He also watches for signs of deteriorating cash flow, which may indicate future problems being stored up by creative profit and loss accounting. After all, it is harder to manipulate cash flow.

He also considers the likelihood of a follow-on from previous warnings: management can sometimes be too optimistic that a downturn in profitability is only short-term. So it’s important to remember the old adage that profit warnings come in threes.

He says he’s always cautious when a management team seems to always be too optimistic. And he takes any profit warning from a new management team with a grain of salt. There’s always the temptation to “copper bottom” the numbers when the new execs can blame the old ones – and give themselves an easier start with profitability levels (on which to base their incentives).

Kirsty Desson, investment director, smaller stocks at abrdn, and fund manager of abrdn Global Smaller Companies.

For starters, Desson suggests investing in quality stocks – companies with a clear and sustainable competitive advantage, a solid balance sheet, a sufficient financial cushion, and a credible management team. They’re less prone to earnings volatility. You could also avoid companies that have issued profit warnings in the past: they’re more likely to disappoint again in the future.

And though profit warnings, by their nature, aren’t predictable, they do tend to fall into two categories that you can monitor – demand-related shocks and supply-related shocks.

Demand shocks tend to occur when there’s a lack of visibility into the sales channel – for example, when products or services go through a distributor or some other third party. In those cases, it can be tricky for management to get a true picture of end demand, and that can lead to “overstuffing” of the channel and a resulting collapse in orders. When a company depends too heavily on a single customer, that can also be a red flag – if that client’s needs change, that can upend everything.

Demand shocks to look out for include big changes in spending in the industry or inflexible company cost structures. Cyclical stocks are particularly vulnerable on this front, since they tend to have limited pricing power. Industry players typically add capacity around the same point in the economic cycle, causing major swings in the supply situation, often followed by price deflation.

With all those risks, Desson says it’s just smart to focus on quality stocks. No model is foolproof, she says. And typically, when a stock in her fund announces a profit warning, she heads for the exits.