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Blog : Strong Fundamentals Can Help You Avoid an Ugly Penny Stock
by John Whitefoot on August 22nd, 2008
I noted recently that scientists at the University of Bristol had discovered, much to nobody’s surprise, that “Beer Goggles” really do make people appear more attractive. Their study noted that those who consumed alcohol, find others…more attractive.
Closer to home, investors can also get distracted by ugly penny stocks simply because they’re trading in single digits. After all, it doesn’t take much, on the surface, for a $0.05 penny stock to double your money.
However, if you take a good look at the company’s technical and fundamental parameters, the dreams of an easy 100% gain, while initially attractive, really aren’t all that realistic once you take a sobering look.
Last week I took an introductory look at how a technical analysis can help you avoid costly penny stock mistakes. This week, I want to look at fundamentals. While not as visually stimulating as chart analysis, fundamentals are the foundation upon which your penny stock is built.
This approach uses the company’s financial statements. It looks at numbers, ratios, as well as the corporation situation. Fundamental analysis looks at everything from revenues and debt, to ratios like price/earnings and debt/equity. You can then compare these with other stocks in general and with direct competitors. A fundamental analysis is a great starting point for screening and researching penny stocks.
Using fundamental analysis you can also look at secondary considerations such as market and industry risk, brand recognition, management team, and barriers to entry for new competitors…among a host of other parameters.
Again, penny stocks play by different rules than their larger cap peers. The fundamentals that drive the price of a blue-chip stock are very different than those which drive a penny stock.
Fundamental analysis is an excellent way to research and rank stocks, but it becomes more difficult when dealing with penny stocks. With a penny stock, it can be challenging sometimes to get access to all the information you may want…and need.
Even then, there are some penny stock companies whose numbers you may want to cast a critical, dubious eye on. Unfortunately, there is no substitute for doing due diligence. There is no fad diet to finding home run penny stocks.
In a nutshell, the prices of penny stocks are driven by certain criteria. A great penny stock does not have to enjoy outstanding marks in all areas, but the more the merrier. At the same time, it may take a handful of strong fundamentals to drive a penny stock higher, it can, in some cases, fall lower on one negative parameter.
By considering all of the factors, you will end up with a clear picture of the best penny stock(s) to invest in.
When it comes to any stocks, increasing revenues is paramount. Obviously, the more money a company is bringing in, the better. However, penny stock companies that are enjoying improving year-over-year revenue growth do not need to increase their operational costs at the same growth rate.
Improving earnings may seem like a no-brainer, but when you see what some people invest in, it clearly isn’t. Companies are in business to make money. End of story. When the smoke clears you look at earnings, and by that I mean, ignore EBITDA, gross income, one time charges and a whole host of other items. Look for how much money it made that quarter and earnings per share.
Positive earnings immediately put a penny stock company above 85% of the others. If the earnings are showing signs of quarterly and sequential growth, you may be able to profit from the underlying shares; especially if the trend of increasing earnings continues.
Low debt levels are also an excellent sign when it comes to penny stock companies. And despite what you may hear…there are loads of excellent penny stocks with huge cash positions and no debt.
At the same time, look for penny stocks that have been paying down their debt quarter over quarter. This generally means a company is paying down their commitments from growing revenue, or stock offerings. All good signs.
Improving financial ratios is also a good indicator. It’s obviously important to know the price of a penny stock and the company’s earnings, but combining the two into the financial ratio, known as the Price to Earnings, or P/E, can be more useful.
This way you can compare companies to each other directly and on even footing. The lower the P/E the better – meaning, that you pay less share price for each dollar of earnings power. A penny stock with a P/E of 5.0 is more attractive than one with a P/E of 75.0. Improving financial ratios is also an encouraging sign.
That said, I don’t know anyone who chooses a penny stock based on a financial ratio. But they will eliminate them at the drop of a hat if the P/E seems out of whack. At a rudimentary level, look at earnings per share more than P/E ratio and look at total debt more than debt/equity.
While delving into the fundamentals of a penny stock may not make for an entertaining afternoon...for most. It certainly makes profiting from a sound penny stock a lot of fun.