What You Should Know about Valuation Ratios and Penny Stocks
Valuation ratios give you an understanding of how attractive penny stock shares are at current prices. Based on the current cost per share, you can see if the stock is relatively expensive or if you’re getting a bargain.
All valuation ratios are derived in relation to share price, and as such, lower results are superior and, ostensibly, imply better value in the shares.
Stocks tend to move back and forth from overvalued to undervalued levels. When they represent very attractive valuations, the theory is that the shares will increase in price as more and more investors recognize the value inherent in the company. This will push share prices to — and even beyond — this intrinsic value.
This investment theory also holds true in reverse, when stocks that are overpriced cause more and more investors to look for companies not selling at a premium.
Price-to-earnings (P/E) is the most common and widely known financial ratio. It simply divides the price of the shares by the earnings the company has generated over the last 12 months and is derived by using the following equation:
P/E is a way of seeing how much earnings power you can buy for the money. It will take less total investment capital to buy more earnings capacity in companies with lower P/E ratios.
The lower the P/E value, the better. For example, if Company A has a P/E ratio of 8 and Company B has a P/E ratio of 24, it means that it costs one-third as much to buy a dollar of Company A’s earnings as it does to buy a dollar of Company B’s earnings.
Keep in mind some important points when using P/E ratios:
No earnings: A fraction can’t be divided by zero. If a company didn’t produce earnings, or operated at a loss, you can’t generate the P/E calculation. On financial websites, this is usually displayed as not applicable.
Looking backward: Because P/E is based on a company’s earnings over the previous 12 months, the ratio is really displaying whether the shares are attractive at current prices based on what they have done in the past. It doesn’t take into account what the company may do going forward.
Corporate life cycle: Expect to see higher P/E ratios for companies in their growth phase of the corporate life cycle. Investors are looking to invest in growing companies, and as such they pay more for the shares.
Your reliance on P/E depends greatly on the nature of the investment.
Lower P/E’s are better in theory, but when they are too low, view them as a warning sign. You may see a P/E ratio of 4 or even 1. What this is really telling you is that investors aren’t willing to pay for the shares, and as the stock falls in value, the P/E ratio falls along with it.
Price-to-earnings-to-growth-rate (PEG) ratio
The price-to-earnings-to-growth-rate (PEG) ratio is great for analyzing penny stocks because it factors in the company’s growth rate. The calculation is generated by dividing the P/E ratio by the anticipated annual growth rate in earnings per share. Here’s the equation:
With PEG ratios, lower numbers are stronger. Anything below 1 should be considered compelling, while PEGs approaching 3 or higher may imply overvalued shares.
For a company with a P/E of 10, with annual earnings per share growth of 20 percent, you divide 10 into 20, for a result of 0.5. That represents a very healthy PEG, and as long as the anticipated earnings growth used in the calculation is reliable, the shares represent significant value.
The price-to-sales ratio compares the current trading price of the stock against their total sales. Here’s the equation:
You can use this ratio to assess how much money you have to invest in exchange for what level of revenue generation capacity.
The price-to-sales ratio is an effective analysis tool for use with penny stock research. As newer and smaller companies generally don’t have earnings, ratios such as P/E and PEG can’t be applied. Because they also have fewer assets, and their shares trade more on speculation and the potential for growth, many of the ratios are not applicable.
With the price-to-sales ratio, lower numbers are stronger. A two-dollar company with one dollar in sales per share would have a price-to-sales ratio of 2. On the other hand, if that same company in had four dollars in sales per share, the ratio would stand at a stronger 0.5.
By comparing the price of the shares to the sales levels, you get an idea of how expensive or inexpensive the share may be at its current price. The ratio is even more helpful when compared with the company's direct competitors, because it will demonstrate how much you would need to pay for shares and for what degree of revenues.
Generally you won’t see a price-to-sales ratio of less than one.
With penny stocks in their early stages, the price-to-sales ratio is one of the most important analysis tools. A strong value near two or less generally implies that the shares represent strong value.
The price-to-cash flow ratio tracks how expensive the shares are in relation to cash flow. Like other valuation ratios, lower numbers represent better value. This ratio is generated by taking the cash flow over the previous 12 months and dividing that by the number of shares outstanding, to provide the total cash flow per share. Then divide the price per share by the cash flow per share. Here’s the equation:
A company trading at $2.50, with a cash flow of $5 per share would have a strong price-to-cash flow ratio of 0.5. If those shares increased to $10 over a few months, without any change in cash flow, then the ratio would become two (10 divided 5 equals 2), and represent significantly less value from the perspective of the price-to-cash flow ratio.