Smart investors who want to keep their money often steer clear of penny stocks. But every once in a while, a penny stock can hit the jackpot. Ford Motor Co. (F) and American Airlines Group Inc. (AAL), for example, started out as penny stocks and are now at the blue end of the trading spectrum. Investors willing to tackle the volatile and lightly regulated world of penny stocks can study key financial ratios to mitigate risks and possibly even make a good investment.
What are Penny shares?
Penny shares, as defined by the US Securities and Exchange Commission, are securities issued by companies that have a market capitalization of less than $ 250 million or $ 300 million. Some experts choose to adopt a cut-off value of $ 1 per share. These stocks are traded on over the counter (OTC) markets. Unlike conventional exchanges such as Nasdaq or the New York Stock Exchange, OTC markets do not require companies to meet the minimum standard requirements to remain on the stock market. These can be companies that do not have a proven track record, unpredictable income or profits, unstable management, and very little disclosure about their operations. Other corporations operate in unproven sectors of the economy or have products or services that have not yet been tested in the market.
Penny stocks are attractive because they are cheap. Investors dream of finding that future Ford Motor or American Airlines and reaping the rewards of exponential growth. However, these low share prices often carry considerable liabilities. Penny shares are very volatile and lack adequate liquidity. This means that even if share prices rise, investors may not be able to sell shares before the prices fall again. The speculative nature of penny stocks requires due diligence and analysis to make investing in these securities more than just a pure gamble.
How to reduce the risks of penny stocks
One way to reduce the risk associated with the improper disclosure of penny stocks is to choose from companies at the OTCQX level of the over-the-counter markets. OTCQX has stricter financial standards for publicly traded companies. These companies must comply with US securities laws and adhere to higher trading standards compared to the other two tiers of the OTC market: OTCQB and OTC Pink. Investors should be especially cautious around companies listed on OTC Pink, as they are not required to file with the SEC and are therefore not regulated.
To discover a solid investment in penny stocks, use fundamental analysis to identify the factors affecting your business and assess the strength of your operations. Keep in mind, however, that with penny stocks, the lack of timely and relevant public information can make it difficult to conduct a good fundamental analysis.
With proper financial disclosure, we can apply some of the same analytical methods that we use for larger companies to determine whether a given penny stock is worth our investment dollars. Strong numbers and a positive trend on the balance sheet, income statement, and cash flow statement are important because much of the share value of a penny is based on future performance expectations.
Liquidity ratios: Liquidity ratios (such as current ratio, fast ratio, cash ratio, and operating cash flow ratio) are the first ratios an investor should calculate for penny stocks. Often penny stocks cannot hedge your short-term liabilities in a set period of time. Lower liquidity ratios (say, less than 0.5) are a good indication that the company is struggling to stay in business or advance its operations.
Leverage ratios: Another important subset of ratios are leverage ratios. They are similar to liquidity ratios in that they focus on the company’s ability to service debt. In this case, what concerns us is long-term debt. Two important leverage ratios are the debt ratio and the interest coverage ratio.
Debt ratio = Total assetsFull responsibility
Here, we look for trends such as whether the debt burden is shrinking or expanding. If you are expanding, it should only be for the purpose of supporting future growth opportunities and business development.
The interest coverage ratio is calculated to determine if the debt load is manageable and if the business generates an adequate level of profit to pay its outstanding debt.
Interest coverage percentage = Interest expensesEarnings before interest and taxes
Higher interest coverage rates are better. Anything less than 2 indicates future long-term debt service problems.
Performance ratios: Performance ratios (such as gross profit margin, operating profit margin, net profit margin, return on assets, and return on equity) help quantify the money earned at each level of the income statement of the company. business. The challenge is that profit margins on penny stocks are usually very small in the early stages of growth. Healthy and steady growth in operating earnings is most critical in the context of penny stocks.
Valuation ratios: Finally, valuation indices help us measure the attractiveness of the stock at its current price. Penny Stock shares can be seriously overvalued. The most common ratio measurement value is the price-earnings (P / E) ratio.
Price-earnings ratio = Earnings per shareCurrent share price
Generally speaking, a lower P / E ratio means a better value per dollar of earnings. However, this relationship is meaningless if the company’s earnings are non-existent or negative, which is often the case for penny stocks. A better measure of the value of penny stocks is the price-earnings-growth (PEG) ratio, which incorporates the annual growth rate of the company’s earnings into the equation above. It is obtained by dividing the P / E ratio by the expected annual growth rate in earnings per share (EPS). As long as the growth rate estimate is reliable, the PEG ratio is a useful measure of value for penny stocks, since much of their value is based on the company’s anticipated future earnings growth.
As mentioned above, P / E and PEG ratios are useless when the company’s earnings are zero or negative. In this scenario, we can use price-sell and price-cash flow relationships, which are much more effective relative to penny stocks.
Price / sale ratio = Sales per shareCurrent share price
A price / sales ratio of two or less is generally considered good value per share.
Price-cash flow ratio = Total cash flow per shareCurrent share price
The price-cash flow ratio is a price-sales variation. It is especially useful to calculate if the quality of earnings is in question.
Once these financial ratios are calculated, we can compare them to the same ratios from previous reporting periods or forecast ratios in the future. We can also compare these ratios with those of direct competitors and the broader market to gain useful insight into the company’s performance and value.
The bottom line
Penny Stock shares rise and fall based on business demand and are often related to company fundamentals and balance sheet. It is often not possible to calculate the correct intrinsic value of a penny stock. Their prices are highly unpredictable and reflect perceived potential over actual value. The company’s level of disclosure is mediocre at best and often non-existent. Trading shares on OTCQX requires regular and accurate disclosure of the company’s fundamentals. Investors looking to trade penny stocks should stick to the OTCQX market and use financial index analysis to mitigate risks.