[Updated: 31-Jul-2021] One Sunday afternoon, I met one of my friends for lunch. He is new but an enthusiastic stock investor. He likes low-priced penny stocks. (Check here for the penny stocks list).
He is that Gujju who has that uncanny knack for picking stocks at the right times. He does it time and again. As a result, he has also upped his confidence.
|SL||Name||Price (Rs.)||ROE-3Y (%)||RoCE-3Y (%)||EPS Growth (3Y) %||GMR Score|
|5||Media Matrix Worldwid||7.1||38.41||30.85||27.21||36.6|
In markets like these (post-COVID), where the general tendency of the price is to go up, overconfidence may be risky. Maybe not now, but this mindset may lead to losses in a normal market scenario.
What he was doing was trading. This is not bad. But it becomes a problem when one thinks he is investing fundamentally, but in reality, he is trading.
This is common, generally, only day traders get attracted to penny stocks. But there is space for investors as well. Remember, even Apple Inc, Google, Microsoft were penny stocks once.
How my friend screen the penny stocks?
He shared with me his stock screening criteria. He told me that he refers BSE 500 index. In this list, he screens those stocks which has a low price (like below Rs.50).
He then checks their fundamentals in moneycontrol.
He had some 10-15 parameters based on which he checks if his screened stocks are worth a buy or not.
More often than not he is able to pick reasonably good stock this way.
[P.Note: I also have my stock analysis worksheet which I use to check the business fundamentals of my stocks. It analyse a stock in less than 15 minutes.]
Why I wrote this post…
It was after meeting my friend that I got a clue of re-writing this blog post all together. Why?
Because I could see its requirement.
I thought that it will be nice if I can explain my understanding of ‘low price penny stock‘ to my readers.
It will make sense to lot of people (like my friend).
So let’s start from the very basic…
What are Penny Stocks?
Penny stocks are mainly characterised by its low market price (below Rs.50 per share). But this is not the only criteria. These stocks are also distinguished by their low market capitalisation.
Penny stocks are necessarily of “small cap” in nature. Hence they will never appear in stock index like “S&P BSE 500”.
Fallacy of my friend…
My friend probably did not want to buy penny stocks. Probably this is why he was referring to BSE 500 Index.
But why he was picking only ‘low price’ stocks from the list? I feel this is due to a misleading assumption. What is the assumption?
Wrong assumption: Stocks of BSE 500 Index has decent fundamentals. Any stock in BSE 500 index, which is trading at low price, must be undervalued.
In some cases this may be true, but in most cases it will not point towards right stocks.
Moreover, by shortlisting only low price stocks, my friend is actually missing out on other stocks which though has high market price, but may still be undervalued.
What my friend must do?
Instead of focusing only on BSE-500 stocks, it is necessary to look beyond. Why? Because by concentrating only on top 500 stocks, he is actually missing a huge opportunity. How?
There are about 3,800+ Stocks listed in National Stock Exchange (NSE). In BSE this number is 5,000+ nos.
If we are concentrating only on Top 500 Stocks (like BSE 500 Index), we are actually covering only 13.2% stocks of the total market.
Most of the investors buy/sell within these Top 500 stocks. Hence there are more chances of finding these stocks at overvalued price levels.
The other 86.8% stocks (beyond BSE 500) are less traded. Hence offer both high risk and high opportunity.
- Why Risk: Because there are chances that fundamentals of these stocks may be weak.
- Why Opportunity: Because if the business is good, it is here that its stocks are more likely to trade at undervalued levels (more than in BSE 500 index).
Define Low Price?
No matter how low is the price, if the underlying company is bad, such shares are worth avoiding. Let’s understand this with an example.
Example: A stock which is trading at Rs.100 can be cheaper than a stock trading at Rs 10. How?
Suppose there are two stocks A & B trading in stock market.
- Market price: “A’s” price is Rs.100 and that of B is Rs.10.
- Earning Per Share (EPS): “A” has a EPS of Rs.10 per share. Similarly “B” has a EPS of Rs.0.5 per share.
- EPS Growth: “A” displays an EPS growth in last 5 years as 12% p.a. Similarly “B” has EPS growth in last 5 years as 11% p.a.
Based on the above data, the stocks “A” & “B” are displaying the following price multiples:
- Price Earning Ratio (P/E): A’s PE ratio is 10 (100/10), and that of B is 20 (10/0.5). This way Stock A looks undervalued.
- PEG Ratio: A’s PEG ratio is 0.84 (10/12), and that of B is 1.81 (20/11). Here as well, A looks undervalued. Read more about PE and PEG ratio here.
Even though the market price of A is higher than B, but it is still a better buy than B. Why? Because it price multiples suggests that.
Filters for Penny Stocks
- #1. Filter: Low market price.
- #2. Filter: Strong underlying Business.
- #3. Filter: Undervalued price.
Why first attention is on “low market price”? Because high price of stocks makes it unreachable for common men. Lets see examples of few high price shares:
- MRF Ltd: Rs.64,800 per share.
- Page Industries: Rs.29,600 per share.
- Eicher Motors: Rs.21,400 per share.
These are stocks of great business, right? But even if they are trading at undervalued price levels, still a common man may not be able to buy even one share of them.
Why it is so? Because of their high current market price.
So where this understanding lead us to? The lower will be the market price of stocks, common men will like it more (like penny stocks)
Now we are ready to know ‘how to evaluate the underlying business’ of penny stocks. We will also know how to check if its shares are trading at ‘undervalued price levels‘ or not. Let’s read further…
1. How to Decode Strong Business?
Let me rephrase my question. How to know if a business is good or not? From point of view of investors, following will highlight if a business is good or not:
- Sales Growth: Sales is growing fast enough? How to know? Check last 5 years sales data in Profit & Loss Account. Then calculate sales growth rate (5Y-CAGR). Sales growth matching inflation rate is considered moderate.
- Profit Growth: Profit is growing fast enough? How to know? Check last 5 years net profit (PAT) data in Profit & Loss Account. Then calculate PAT growth rate (5Y-CAGR). PAT growth matching inflation rate is considered good. Read more about analysing profit margins.
- EPS Growth: EPS is growing fast enough? How to know? Check last 5 years EPS data in Profit & Loss Account. Then calculate EPS growth rate (5Y-CAGR). EPS growth more than inflation rate is considered great. Comparing EPS growth with the competitors will also be a good idea. Read more about high EPS and its growth.
- ROE: Is the company profitable enough for its investors? How to know? Check its ROE history, and if it is growing or not. First, calculate the ROE ( = PAT / Net Worth). A good company will either maintain its ROE, or improve it, over a period of time. Calculate last 5 years ROE. Then calculate ROE growth rate (5Y-CAGR).Even if the ROE has increased marginally, it is outstanding.
- Debt: Is the company relying too much on debt? How to know it. Check its Debt/Equity ratio history, and if it is growing or not. First, calculate the Debt/Equity ratio ( = Debt / Net Worth). A good company will keep reducing its debt dependency over time. It means, with time, its Debt/Equity ratio shall fall. Calculate last 5 years D/E ratio. Then calculate D/E growth rate (5Y-CAGR). D/E growth in negative means, the company is doing good.
These are few common check-points using which we can judge the business fundamentals of a company. But if you would like to do a more detailed stock analysis, do check my stock analysis worksheet. This worksheet will help you to estimate the following for your stocks:
- Free cash flow.
- Intrinsic value.
- Overall grading for stock.
2. How To Verify Undervaluation of Stock?
We can use three financial ratios which will highlight if the current price of stock is undervalued or not.
- P/E ratio: This is price to earning ratio. P/E ratio can be calculated by this formula ( =Price / EPS). Calculating P/E ratio is easy. But I will suggest a better trick here. Calculate last 5 years P/E ratio and plot a curve. How to do it? Prepare this table first. Check the PE trend in last 5 years. How to do it? By plotting a curve. If P/E is falling, it is hinting at undervaluation, and vice versa.
|Year||Price (P)||EPS (E)||P/E|
- PEG ratio: This is ratio between PE and “stock’s potential future growth rate”. P/E ratio can be calculated by this formula ( =PE / EPS growth rate). PEG is a very useful financial ratio for estimating price valuation of a stock. PEG less than 1, is a sign that the stock is undervalued. A stock with high PE, but low PEG (<1) is good. A stock with low PE, but high PEG (>1) is not good. Read more about PEG ratio of stocks here…
- Dividend Yield (DY): This is the ratio between dividend per share and price. DY ratio can be calculated by this formula ( = Dividend per share / price). Dividend yield is a very reliable “value indicator”. Why? Because a stock which will pass this test, will be undervalued for sure. How to do this analysis? Again we will rely on a 5 years trend, instead of one year data. Calculate last 5 years dividend yield, and plot a curve. Rising dividend yield is a sign that the share price is moving towards undervaluation. Read more about dividend paying stocks here.
|Year||Price||Dividend Per Share||Dividend Yield|
I once read an article on “penny stocks for long term investors“. The writer was completely biased against penny stocks. Probably he was looking at penny stocks just as a “trading option”.
But for me, penny stocks can also be a good long term investment. Why? Because the growth potential of a good penny stock far exceeds its large cap counterparts.
So how to go about investing in penny stocks? I have mentioned my filters for penny stock in the article above, but there is something more I would like to add here.
There is a difference between large cap and small cap stocks. Large cap stocks are ones which has a proven reputation. But small cap penny stocks has still not gone through as much scrutiny.
Hence I follow this strategy for myself in dealing with penny stocks. I use my filters to identify 2/3 penny stocks every 6 months. But I do not go ahead and buy them instantly.
I add them to my watch list, and keep a track of them for at least a month. During this time, I try to read as much as possible about them. I use “Google Alerts” to receive notifications about them in my inbox.
Once I start feeling more confident about them, I go ahead and buy.
Read More: How I’ll do day trading?