When the stock price is the only factor considered, a retail investor might think that the quality of the company that is trading at $ 100 is much higher than the one that is trading at $ 0.10. As we have seen in the example, this may not always be the case as they are identical, so it is important to take into account the number of shares available.
Beware of dilution
Another factor to consider when trading penny stocks is dilution. The number of shares outstanding can often skyrocket out of control through the use of tools such as employee stock options, issuing shares to raise capital, and stock splitting. If a company issues shares to raise capital, which many small companies must do, it can often dilute the percentage of ownership of other investors.
For example, if Company A issued an additional 110 million shares in an effort to raise capital, then it is natural for the share price to decline to $ 0.09 ($ 0.09 keeps the market capitalization stable at $ 100 million). In this case, the underlying business has not changed. But the number of shares has caused the share price to go down.
When trading penny stocks, it is important to find a company that has a strong hold on its stock structure because constant dilution erodes the value of the shares held by existing owners.
How to identify a potential winner
Most companies that trade stock prices below a dollar have relatively small market capitalizations, but as shown above, this is not always the case. When it comes to investing, it is important to consider the strength of the company’s fundamentals.
Does the management team depend on the issuance of new shares to raise capital? Is the company profitable or will you be able to make a profit based on your current business structure? Can the company compete in its sector? For those who are willing to do their homework, there are definitely gems that can be found that meet these criteria.
As you can see from the GGP, Inc. (GGP) chart, the company’s stock price dropped to a penny share range during the 2008 financial crisis. For those who don’t follow the company, GGP owns , manages, leases and rebuilds real estate as regional shopping centers. Investors keeping an eye on the stock structure, underlying fundamentals, and competition may have identified GGP as a prime candidate and benefited from a tremendous surge in the years that followed.
Another key factor to consider is that certain sectors are more common for finding stocks that trade below a dollar. For example, the metals and mining sector is well known for the number of companies that trade pennies.
Given the reliance on the issuance of new shares to raise capital to fund operations, increased competition, and aggressive incentive plans, it is particularly important for investors to pay attention to the factors mentioned above in order to be successful. For those who are willing to do their homework, they will be able to identify the winners.
The bottom line
When most retail traders look at a penny stock, they often ignore the underlying fundamentals, such as the number of shares outstanding. As with all investments, it is important to examine the underlying fundamentals of a company and overlay this information with details, such as how poorly stocks are being diluted through the use of stock splits, stock options, and the issuance of new shares to raise capital.
Stock dilution hurts existing shareholders and is particularly common with penny stocks. Keeping an eye on the stock structure and other fundamental factors mentioned above will help investors find winners.