Wise investors who want to keep their money usually stay away from penny stocks. But once in a while, a penny stock can hit the jackpot. Ford Motor Co. (F) and American Airlines Group Inc. (AAL), for example, both started out as penny stocks and are now at the blue chip end of the trading spectrum. Investors who are willing to brave 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 Stocks?
Penny stocks, as defined by the U.S. Securities and Exchange Commission, are securities, usually issued by small companies, that trade at less than $5 a share. Some experts choose to adopt a lower cut-off value of $1 per share. These stocks trade in over-the-counter (OTC) markets. Unlike conventional exchanges like NASDAQ or the New York Stock Exchange, over-the-counter markets do not hold companies to minimum standard requirements to remain on the exchange. These may be companies that have no proven track record, unpredictable revenues or earnings, shaky management, and very little disclosure about their operations. Other penny stock companies operate in unproven sectors of the economy or have products or services that are yet to be 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. Yet, these low share prices often come with considerable liabilities. Penny stocks are highly volatile and lack adequate liquidity. This means that even if stock prices rise, investors may not be able to sell shares before prices fall again. The speculative nature of penny stocks requires due diligence and analysis to make the investment in these securities something other than a pure gamble.
How to Reduce the Risks of Penny Stocks
One way to reduce the risk associated with the inadequate disclosure of penny stocks is to pick from companies in the OTCQX tier of the over-the-counter markets. OTCQX has stricter financial standards for the listed companies. These companies must comply with U.S. securities laws and meet higher standards of operations when compared to the other two OTC market tiers—OTCQB and OTC Pink. Investors should be especially wary of companies listed on OTC Pink as they are not required to file with the SEC and are therefore not regulated.
To uncover sound penny stock investment, use fundamental analysis to identify factors affecting the company and to assess the strength of its operations. Keep in mind though, with penny stocks, the lack of timely and pertinent public information may make good fundamental analysis difficult to complete.
Given adequate financial disclosure, we can apply some of the same analytical methods we use for larger companies to determine if 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 so much of the penny stock’s value is based on future expectations of performance. (For a list of financial ratios and their calculations, see Financial Ratio Tutorial)
Liquidity Ratios: Liquidity ratios (such as the current ratio, quick ratio, cash ratio, operating cash flow ratio) are the first ratios that an investor should compute for penny stocks. Often, penny stocks are unable to cover their short-term liabilities in a given time frame. Lower liquidity ratios (say less than 0.5) are a good indication that the company is struggling to stay in business or to 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 cover debt. In this case, it is the long-term debt that we are concerned about. Two important leverage ratios are the debt ratio and the interest coverage ratio.
Here, we are looking for trends such as if the debt load is shrinking or expanding. If it is expanding, then it should only be for a reason of supporting future growth opportunities and business development.
Interest coverage ratio is computed to determine if the debt load is manageable and if the company generates adequate level of earnings to service its outstanding debt.
Higher interest coverage ratio numbers are better. Anything less than two signals trouble in servicing long-term debt in the future.
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 made at each level of the company’s income statement. The challenge is that profit margins of penny stocks are often very small in early stages of growth. Healthy and consistent growth in operating earnings is more critical in the context of penny stocks.
Valuation Ratios: Finally, valuation ratios help us measure the attractiveness of the stock at its current price. Penny stock shares can be seriously overvalued. The most common ratio measuring value is the price-to-earnings (P/E) ratio.
Generally speaking, a lower P/E ratio signifies better value-per-dollar of earnings. This ratio, however, becomes meaningless if company earnings are nonexistent or negative, which is often the case with penny stocks. A better measure of penny stock value is the price-to-earnings-to-growth (PEG) ratio, which incorporates the company’s annual earnings growth rate into the above equation. It is derived by dividing the P/E ratio by the expected annual growth rate in earning per share (EPS). Provided that the growth rate estimation is reliable, the PEG ratio is a useful measure of value for penny stocks since much of their value rests in the anticipated future growth of the company’s earnings.
As mentioned above, P/E and PEG ratios are useless when company earnings are zero or negative. In this scenario, we can use the price-to-sales and price-to-cash flow ratios, which are far more effective with regard to penny stocks.
A price-to-sales ratio of two or less is generally considered a good share value.
The price-to-cash flow ratio is a variation of price-to-sales. It is especially useful to compute if the quality of earnings is under question.
Once these financial ratios are calculated, we can compare them with the same ratios for the previous reporting periods or forecast ratios into the future. We can also compare these ratios to those of direct competitors and the market overall to gain useful insight into the company’s performance and value.
The Bottom Line
Penny stock shares rise and fall based on the trading demand and are often only loosely related to company fundamentals and the balance sheet. It is often not possible to calculate a penny stock’s correct intrinsic value. Their prices are highly unpredictable and reflect perceived potential over actual value. Company disclosure level is at best mediocre, and often nonexistent. Stocks trading on OTCQX require periodic and accurate disclosure of company fundamentals. Investors who wish to trade in penny stocks should stick to the OTCQX market and use financial ratio analysis to mitigate risks.