Financial Trends to Look for in Penny Stock - dummies

Financial Trends to Look for in Penny Stock

By Peter Leeds

More important than the actual reported numbers in a penny stock company’s financial statements are the trends in those underlying results. Because investors try to anticipate growth rather than react to it, you can get the best investment results by considering where a company is going instead of where it is. This strategy is especially relevant for penny stocks, because so much of their value is based on forward-looking speculation.

By observing, anticipating, and reacting to trends in the financial statements, you can position yourself for success. Whether this involves investing in companies with rapidly increasing revenues or buying stocks that are aggressively paying off their debt or increasing their market share, getting ahead of strengthening fundamentals before they’re common knowledge gives you a great advantage over other investors.

Consider a company that has seen 10 percent sales growth every quarter for the last four years. Barring any material changes in the company’s fortunes, you may expect similar progress for the upcoming quarterly report. This is a simplified example, but the concept is clear.

Anticipate any trends that will show up in revenues, earnings, assets, liabilities, debt load, or any other items tracked on the financial statements. Such trends won’t always appear, or even be fully reliable, but when you spot one that could have an impact on the share prices of the underlying company, you have a significant advantage.

Some trends in the financial results that may prove very helpful, and by extension very profitable, include those in

  • Revenues: A sales increase from one quarter to the next, or from year to year, can imply an increasing market share, more widespread adoption of a product, or more frequent or larger orders from existing customers. You want to see growth in revenues. An even better sign is if that growth accelerates to an even greater rate.

  • Debt: Many penny stocks take on a lot of debt early in their life cycle because they don’t have significant revenues or they incur costs to get established. Companies with little debt have lower interest payments and the potential to take on debt. When you see a company continually pay down its obligation from one quarter to the next, it is becoming fundamentally stronger.

  • Assets: In most cases, the asset position of companies will remain relatively stable over the quarters. However, a growing company may see its current and long-term asset positions increase as its inventories, intellectual property, factories, or otherwise, become more valuable.

  • Liabilities: Often a growing company will see its liabilities increase rather than decrease. This is usually due to larger inventory purchases to fulfill bigger orders, or the need for more staff and equipment or a new factory. You don’t want to see a growing liability trend if it’s not equaled or exceeded by similar moves in the assets.

  • The asset to liability mix: Pay close attention to changes in the mix of assets to liabilities. A trend of decreasing liabilities concurrent with an expanding asset position is a very strong trend for a company. As a penny stock becomes more fundamentally solid, the asset to liability mix should improve.

  • Earnings: Companies report how much money they make in their earnings, the factor with the greatest impact on share price. Anticipate trends in upcoming earnings and you will have a good idea of where shares are heading.

  • Profit margins: Profit margins illustrate how much money a company is making by selling its goods. As it find ways to make greater profits, either by selling for higher costs or enjoying economies of scale to produce products less expensively, its margins will improve. A trend in stronger margins is very positive for a company because it will reflect greater profits.

  • Financial ratios: Financial ratios provide a greater understanding of the business activities by dividing one number from a company’s financial statements by another number. For example, the price per share divided by the earnings per share generates the price/earnings (P/E) ratio for the stock; the ratio presents the company’s earnings capacity to investors in a clear fashion, especially when compared to the P/E’s of other businesses in its industry.

    If trends in a penny stock’s ratios improve quarter after quarter, you know that the company is strengthening.

Companies have a life cycle, which begins with the start-up phase, and proceeds through growth, maturity, and finally decline. Most penny stocks are in the start-up or growth phase, where they take on costs to get established and post losses while they try to generate enough revenue to cover their bills.

Those corporations that make the transition from start-up to growth phase often enjoy the greatest increase in their share price, although many companies in the growth phase end up going out of business if their concept doesn’t work.

After passing into the mature phase, many companies have captured most of the growth they can, and they enter into a period in which they hold their position or even pay dividends to shareholders with the money they make rather than invest it. Mature companies eventually enter a phase of decline, unless they can restructure or reinvest themselves to adapt to a world that may have changed significantly.