Are You Overpaying For Your Penny Stocks?

| July 22, 2013 | 0 Comments

Does this sound familiar? 

After countless hours of diligent research, you finally find that penny stock diamond in the rough.  A tiny, unknown growth company that has a unique product or service, a top-notch management team, and a solid financial profile. 

So naturally, you jump on the opportunity. 

You quickly log in to your brokerage account and invest your hard earned money into the stock.  As you press the buy button, your head is spinning with dreams of making an outrageous fortune.

But then it happens…

As soon as the shares hit your account, your seemingly perfect penny stock starts to head lower.  No problem you tell yourself, “It’s just a temporary pullback.”  Of course, as fate would have it, the stock defies all logic and reason and continues to drop over the following days and weeks.

And before you know it, your ticket to untold riches has lost half its value or more.

If this has happened to you, then you know it’s one of the most frustrating things an investor can experience.  But don’t get too down on yourself, there’s a lesson to be learned here. 

That lesson is… you have to do a better job of assessing a stock’s value before you buy it.

Finding a quality company is just one step in any penny stock research regimen.  Another equally important step is figuring out if the stock is overvalued, reasonably priced, or undervalued.

You’ve all heard the old adage, “Buy low and sell high.”  Well, it’s more than just an old saying.  It’s a simple bit of Wall Street wisdom that you ignore at your own peril.  Millions of investors have lost their shirts by overpaying for stocks of great companies. 

So, how do you determine if a penny stock is a good value?

It’s easier than you might think.  You don’t need an MBA in Finance to properly value a stock.  You just simply apply one or more of the various stock valuation metrics.

For example… 

Most investors are familiar with earnings-based metrics… the price-to-earnings ratio, the earnings-to-price ratio, and the PEG ratio to name a few.  These are simple but effective valuation tools every investor should know how to use.

However, these metrics aren’t foolproof.

The problem is… earnings-based valuation metrics don’t always apply to penny stocks.  As you probably know, most publicly traded penny-sized companies are emerging growth companies that are not yet profitable. 

And if a company doesn’t have earnings, its stock won’t have a PE ratio or PEG ratio to use in your valuation analysis.

However, a lack of earnings doesn’t necessarily make a company a bad investment.  On the contrary, these stocks are ground-floor investment opportunities for savvy investors.

But if a company doesn’t have earnings, how do you determine if its stock is overvalued or not?

That’s where the price-to-sales (P/S) ratio comes in. 

This ratio is one of my favorites for assessing the value of any stock.  But it’s particularly useful for determining the value of stocks for which the earnings-based metrics don’t apply.

Here’s how it works…

To calculate the P/S ratio, you simply take the company’s market cap (the number of shares multiplied by the share price) and divide it by the company’s total sales over the past 12 months.  The lower the ratio, the more attractive the stock.

However, as with any valuation metric, the P/S ratio is only useful if you compare it to those of other stocks, preferably those in the same industry. 

For example, a stock with a P/S ratio of 0.5 in an industry with an average P/S ratio of 2.0 would appear to be undervalued relative to its peers.  In other words, the stock should enjoy significant upside as its P/S ratio moves closer to the industry average.

On the flip side, if a stock has a P/S ratio significantly higher than the industry average, it’s probably overvalued.  As such, the shares are more likely to drop as the P/S ratio is brought more in line with the industry average.

No question about it, the P/S ratio can help you find undervalued penny stocks and avoid overpaying for penny stocks.  If you’re not using it, you should add it to your research toolbox immediately. 

But keep this in mind…

Valuation analysis is just one step in the research process.  While valuation metrics can certainly help you identify unrecognized potential, they’re no substitute for diligent evaluation of company fundamentals.

Profitably Yours,

Robert Morris 

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Category: Penny Stocks

About the Author ()

Robert Morris is the editor of Penny Stock All-Stars, an investment advisory focused on discovering small-cap and micro-cap stocks that are destined to become the market’s next Blue Chips. The Wall Street veteran and small-cap stock specialist is also a regular contributor to Penny Stock Research. Every week, Robert shares his thoughts with our readers on a variety of penny stock-related topics. In addition to Penny Stock Research, Robert also writes frequently for two other free financial e-letters, ETF Trading Research and the Dynamic Wealth Report. He’s also the editor of two highly successful and popular investment advisories, Biotech SuperTrader and China Stock Insider.

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