Penny stocks, as the name suggests, are stocks of those companies that trade with a low share price, often less than $1. Given such a low share price, there is an understandable draw for retail investors who dream of buying 10-cent shares and seeing them rise to ten or more times that sum.

But before dabbling in penny stocks, an investor should note several key factors that affect the way these stocks trade and have a solid understanding of the inherent risks that follow. 

Share Price and Valuation

One of the biggest mistakes that retail investors make is that they view penny stocks as being affordable. There is a sense that one is getting a better bang for their buck when they buy thousands of shares rather than a couple of a company with a higher share price.

At first glance this thinking seems rational, because after all, a $1,000 investment in Company A that trades at $0.10 allows the investor to buy 10,000 shares, rather than 10 shares of a Company B that trade at $100. The key piece of information that is often overlooked is the number of shares outstanding.

Let’s assume that Company A and Company B shared identical fundamentals with the exception of the number of shares outstanding. For simplification, let’s also assume both companies have a market capitalization of $100 million. 

Company Name 

Shares Outstanding 

Share Price 

Market Cap

Company A

1,000,000,000

$0.10

$100,000,000

Company B

1,000,000

$100

$100,000,000

When share price is the only factor taken into consideration, a retail investor might think that the quality of the firm trading at $100 is much higher than the one trading at $0.10. As we’ve seen in the example, this may not always be the case since they are identical, so it is important to consider the number of shares available.

(For a better understanding of this topic, see The Basics of Outstanding Shares and the Float.)

Beware Dilution

Another factor to be conscious of when trading penny stocks is dilution. The number of shares outstanding can often balloon out of control through the use of tools such as employee stock options, share issuance in order to raise capital and stock splits. If a company issues shares to raise capital, which many small companies need to do, then it can often dilute the ownership percentage held by other investors.

For example, if Company A issued an extra 110,000,000 shares in an effort to raise capital, then it's natural that the share price would decline to $0.09 ($0.09 keeps the market cap steady at $100 million). In this case, the underlying business hasn’t changed. But the number of shares has, causing the share price to drop.

When trading penny stocks, it's important to find a company that has a strong grasp on its share structure because consistent dilution erodes the value of the shares held by existing owners.

(For further reading, see The Dangers of Share Dilution.)

How to Spot a Possible Winner

Most companies that trade with share prices under a dollar have relatively small market capitalizations, but as shown above, this doesn’t always have to be the case. When it comes to investing, it is important to consider the strength of the company’s fundamentals. Does the management team rely on issuing new shares to raise capital? Is the company profitable or will it be able to turn a profit based on its current business structure? Can the company compete in its sector?  For those willing to do their homework, there are definitely gems that can be found that meet these criterion.

As you can see from the chart of GGP, Inc. (GGP), the company’s share price got battered down into penny stock range during the financial crisis of 2008. For those who don’t follow the company, GGP owns, manages, leases and redevelops real estate such as regional malls. Investors who kept an eye on the share structure, underlying fundamentals and competition could have identified GGP as a prime candidate and profited from a tremendous rise in the years that followed.  

Another key factor to consider is that certain sectors are more common for finding stocks that trade under a dollar. For example, the metals and mining sector is well-known of the number of companies that trade in the pennies.

Given the reliance on issuing new shares to raise capital to fund operations, increased competition and aggressive incentive plans it's particularly important for investors to pay attention to the factors mentioned above in order to be successful. For those willing to do their homework, you’ll be able to identify winners.

(For more, read The Lowdown on Penny Stocks.)

The Bottom Line

When most retail traders look at a penny stock, they often ignore underlying fundamentals, such as the number of shares outstanding. As is the case with all investing, it's important to examine a company’s underlying fundamentals and overlay this information with details, such as how badly the shares are being diluted through the use of stock splits, stock options and issuing new shares to raise capital.

Share dilution hurts existing shareholders and it's particularly common with penny stocks. Keeping an eye on the share structure and other fundamental factors mentioned above will help investors find winners.

(For more, check out Investopedia's Day Trading Academy.)

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