Financial Ratios and Penny Stocks - dummies

Financial Ratios and Penny Stocks

By Peter Leeds

Whether deciding between different investment options or industries or choosing among various penny stocks and large cap companies, financial ratios allow you to place them all on equal footing for comparison purposes.

Eliminate penny stock company size as a factor

Financial ratios allow an investor to compare companies of all sizes directly to one another. Even if your sample has some companies that are 100 times larger than others, you can use ratios to see which shares make the best use of their funds, have the most debt proportionally, or generate the greatest profits from their sales.

By generating ratios, you eliminate company size as a factor. Two companies with a profit-to-earnings (P/E) ratio of 12 are theoretically equally profitable, even if one is a penny stock trading at 40¢ per share, and the other is a large cap company whose stock trades at $500 per share.

With penny stocks, it becomes increasingly important to use ratios in your analyses. Low-priced shares very often have few competitors, let alone those with similar share prices and company sizes.

By using ratios, you increase the size of the comparison pool, which in turns makes your data more reliable. It is also important to get an idea of how a penny stock compares to the much bigger players in the industry, to assess what advantages that smaller company has, if any.

Compare penny stocks across industries

By using financial ratios, you can also compare companies trading in completely different industries. For example, using ratios you may be able to demonstrate that shares from the mining industry represent much better value than those in the biotech field.

Many investors believe that companies with lower share prices represent better value. Share price is actually a reflection of the worth of the company divided by the number of shares in existence, with additional factors such as growth rate and the future expectations of investors coming into play. As such, attractive valuations can come from shares of any price.

By applying financial ratios, you will sometimes see that higher-priced shares represent more compelling value than their lower-priced counterparts.