How to Idenify Undervalued Penny Stocks
In the past I have received dozens of emails from traders wondering how to research and find undervalued penny stocks. I will give some tips on how to check if a company is over or under-valued. Researching stocks involves alot of time and effort, but eventually you will be rewarded for your hard work.
1. Financial Ratio’s
Financial ratios of a company can tell you alot about a company. I use Yahoo Finance, which provides them for you. Most important financial ratio’s
- Price to Earning’s ratio
- Current ratio
- Debt/Equity ratio
The most common financial ratio is the price to earnings ratio. To find the P/E ratio simply divide the price of shares by the company’s latest annual earnings. Lower numbers are stronger and indicate whether or not the company maybe a solid investment. If the P/E ratio is high it reveals that the company is over-valued and hence would represent a risky investment. During market bubbles P/E ratios tend to be alot higher than normal.
The current ratio is a liquidity ratio that measures a company’s ability to pay short-term obligations. The current ratio formula is current assets divided by current liabilities. Higher numbers are stronger. This ratio gives us an idea if the company has the ability to pay back its short-term liabilities with its short-term assets. A number under 1 suggests that the company will be able to meets its obligations.
Debt/Equity ratio divide total liabilities by stockholders’ equity. A high Debt/Ratio implies that a company has been aggressive in financing its growth with debt. The debt/equity ratio depends on the industry in which the company is in. Capital-intensive industries (car manufacturers) tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity generally below 0.5.
To identify the strength of a financial ratio compare them to a companies competitors in the the same industry and companies of much different sizes. By comparing a stocks P/E ratio you can easily see how strong the company is when in comparison to its industry, its competitors, and the overall stock market.
There are alot more financial ratios than the three I have mentioned above, you can use the internet to find about other financial ratios. Also remember these ratios are freely available on websites like Yahoo Finance and MSN Money.
2. Insider Trades
Top management, executives, company, person or organization that owns more than 10% of a publicly traded company is considered to be an insider. They are legally required to report any transactions in the companys stock. Generally insider buying is seen as a positive sign while on the other hand insider selling is seen as negative. If a CEO believes his company is undervalued he will likely purchase shares of his own company. Its a positive sign when a CEO is accumulating more and more shares. Its a red flag when a CEO is dumping shares onto the open market. Or sometimes a CEO will just sell shares to buy a new car. While insider trades can be an effective indicator, always take it with a grain of salt.
3. Institutional Holdings
Another sign that shows a penny stock may be undervalued is, if a corporation owns a large amount of the total shares outstanding. It also may be:
- Hedge funds and mutual funds believe the shares are undervalued.
- Competitors may be trying to hedge against their own success or failures.
- Companies looking to potentially takeover a company which are looking to expand.
A greater number of institutional holdings, with a greater number of institutions generally demonstrate that highly experienced money managers and professional analysts believe the shares represent a solid investment. Once again you can check institutional holdings on Yahoo Finance.
4. Share Buybacks
A company with extra cash may think that the market does not value its shares realistically, so it may buy back shares from the open market. Once the shares are bought back they become retired, which means they no longer exist. This increases the value of the remaining shares.
5. Share Dilution
This is the opposite of buybacks. Dilution involves a company issuing more shares, which decreases the value of each share. This can be a sign that company is burning thorough their cash and desperate to raise money. If a company continues to dilute their shares this will cause share prices to fall rapidly. These tends to happen to many biotech companies. Sometimes well-run companies with a solid business model can use the extra money from share dilution to expand the company, which in the long run could make your shares worth more.