How to Determine if a Company is Overvalued or Undervalued

May 28, 2014 | Fundamental Analysis, Penny Stock Tips

One of my mains strategies for trading penny stocks is based upon finding undervalued companies and waiting for the market to realize their true value. These are the only penny stocks I will actually “invest” in, however, I still use my “Mentally Long Swing Trader Strategy” to protect my investments. Determining whether or not a company is properly valued, undervalued, or overvalued should be the first step of your due diligence/fundamental analysis. Most penny stocks are terrible companies that should be worth $0, so the majority of them are overvalued. Undervalued stocks are gems in the world of penny stocks. So, first things first, let’s talk about why a company’s valuation matters.

Why Does it Matter?

When you buy stock in a company and plan to hold your shares long term, you are buying a share of the company. Like any purchase in life, you want to make sure you are getting a good deal. Take an iPad for an example. At the time I’m writing this, you can get an iPad Air for $499 . If you go to a store and they are selling the iPad Air for $800, you would leave because that is ridiculously overpriced. Contrarily, if you found the iPad Air for $400 at another store, you would probably purchase it because it is a great value. The same logic applies to stocks. You don’t want to buy stocks that are overpriced (overvalued) because you won’t be getting a good deal.

Determining a company’s valuation is the first step to any further fundamental analysis, as it will help you assess every other piece of information you encounter. Whenever you see hear people talking about how good a company is fundamentally, you want to resort back to the company’s current valuation. Someone may say, “”X Stock” has major contracts with huge companies. They already brought in $1 million in revenue the first quarter of this year.” That statement alone sounds pretty good, especially if the company is trading at only a few cents per share. However, what if you looked at the company’s market cap and saw the company was already valued at $200 million? $1 million in revenue may not seem as impressive. Sometimes, positive news is already factored into a stock’s price. This is why properly valuing a company is the basis for all future fundamental analysis.

The Most Important Factor to Look At: Market Cap

The first and most important factor you will want to look at is a stock’s market cap. The market cap is calculated by multiplying the stock current share price by the amount of outstanding shares. So, if a stock trades at $0.04/share and there are 100,000,000 shares outstanding, the market cap is $4 million. You can see a company’s market cap by going to the “Company Info” tab on the OTC Markets website or you can calculate it yourself.

In another post, I talked about how market cap does and does not matter. To summarize, market cap doesn’t really matter for traders but it matters for investors. So many stocks have over inflated market caps but still run up exponentially. That being said, for the sake of finding undervalued companies, I use market cap as the basis for my future analyses.

The market cap is the value of a company as determined by traders and investors. If the market cap is $4 million, the company is valued at $4 million. Your next step is to decide whether the company is worth more or less than its current market cap.

What to Look At Next

The Basics

Common sense will go a long way here. Look at a company’s financial statements first. Analyze the raw data and draw some conclusions. Be confident and unbiased in your analysis. Look at revenues, profits, assets, etc. If a company is valued at $4 million and only has $3,000 in the bank, there might be a problem. That being said, the company may own $2 million in property to make up for it. Once again, always resort to common sense. If a company has $2 million in assets, but $1.8 million of them are intangible assets, is that as good as cash in the bank? Rhetorical question, but you get the point. Think deeply about the financials and use them to tell a story about the company. You can come to some great conclusions.

There’s no methodical, scientific approach to analyzing the financial statements in this way. It is an art and every company will be different. You don’t need some fancy degree in accounting to make sense of the data. As stated above, just use common sense and create a story for the company. You need to learn to be able to make sense of financial statements in order to be able to properly assess a company’s value. For example, picture a company releases the following data:

You could just look at the numbers and evaluate them. You’d see increased revenues and profits, and decreased cash. Now, try telling a story with it:

“During the first quarter the company did very well and brought in $1 million in revenue. Their new product just launched and there was a huge demand for it. They had an astonishingly high profit margin of 80%. The company’s efficiency for the quarter was reflected by the fact that they have $1 million in cash saved up. As the 2nd quarter came around, the company wanted to scale up their operations to increase revenues. Demand for their product was still high and they were able to double their revenue, however, they had some issues scaling up their business model. Profit increased, however, the profit margin decreased by 20%, so the company may not be able to scale up very efficiently. This could be cause for concern in upcoming quarters. This theory would be supported by the fact that the company’s cash supply was cut in half by 50% as the company strives to increase their revenues. A look at the cash flow statement should tell me how all of that money was spent.”

I know I diverged from my main point a bit, however, it is crucial that you have a way to understand financial statements in a way that makes sense to you. Telling a story helps you develop a more holistic view on the company’s business operations. I’m not saying you should only look for growth, revenue/profits, and cash. I am saying that you should analyze a company’s financial statements and know what that means in terms of how efficiently the company is running their business.

You should be comparing the numbers to the company’s market cap to see if they are in line. Once again, this is an art, and different investors will draw different conclusions. There’s nothing wrong with that. Just make sure to create a system that works for you.

After you look at the raw data, you can run some additional analyses to determine a company’s value.

EPS and P/E Ratio

This is one of my favorite/main methods of valuing a company. It is intended for big board stocks, however, it can be applied to penny stocks as well. After all, if you are looking at penny stocks as “investments”, you should treat them as such.

EPS stands for earnings per share. It is calculated by taking the company’s yearly net income and dividing it by the amount of outstanding shares. For example, if a company had a yearly net income of $1 million and has 100 million outstanding shares, the EPS would be $0.01. Always make sure to calculate the EPS manually because sites like Yahoo Finance rarely have the correct data for penny stocks. Most penny stocks have negative EPS, so any positive EPS is a good sign, however, you will want to use the P/E ratio to determine how good the EPS really is.

P/E stands for Price/Earnings and it is a popular ratio for determining a company’s value. To calculate the P/E of a company, you will want to divide the current share price by the EPS. So, if a stock has a share price of $0.05/share and an EPS of $0.01, the P/E ratio is 5.

There is no ideal P/E ratio. Average P/E ratios vary across industries. I like to look at the average P/E ratios for an industry and compare it to a company I am analyzing. You can find a list of average P/E ratios by industry right here. So if a company is in the “Accident & Health Insurance” industry (Average P/E of 10.5), and has a P/E ratio of 5, it could be argued that the company is overvalued.

The next step is determining what price a company is fairly valued at.

Determining a Fair Valuation

Determining what a fair share price is for a company is important because stocks can easily go from being undervalued to overvalued. If you bought a stock because it was undervalued and the market drives the price up, you will want to reevaluate your stance. Far too often, I encounter people who expect a stock to run forever because it’s a good company. The fact remains that a good company can still be overvalued. You need to know a company’s fair value so you can plan an exit strategy. If you got into a stock because it was undervalued, you should get out when it becomes undervalued.

Here’s how I determine a company’s fair value (based on share price). I’ll use an example to illustrate the point.

Let’s say you find a solid company in the “Auto Parts” industry (Average P/E of 18.6).

The company is priced at $0.05/share

The EPS is .$0.01.

Current P/E for this company is 5.

Right now the company could be considered undervalued. It becomes fairly valued when the P/E reaches 18.6. You can figure out the fair share price by doing the math.

P/E = Price Per Share / Earnings Per Share

18.6 = Price Per Share /.01

Price Per Share = 18.6 * .01

Price Per Share = $0.186

Based on this calculation, the stock is undervalued when below $0.186/share and overvalued when above $0.186/share. You can plan your entries and exits accordingly.

While this valuation tactic is helpful in determining a company’s value, it does not guarantee anything. A company can stay undervalued for a very long time. Additionally, the valuation was based off of industry averages and P/E ratios will vary within the industry. That being said, it’s a good start. If you find a company like the one used in this example, there is a lot of margin for error. According to the above calculations, the stock can run 372% before it is overvalued. Even if it ran 100%, that would be a good investment. If you find company’s that are extremely undervalued, there is a lot of wiggle room in your calculations.

The last thing you will want to account for is a company’s growth and upcoming catalysts.

Accounting for Growth

The PEG Ratio

The PEG ratio is similar to the P/E ratio, except it also accounts for company growth. I rarely use the PEG ratio, however, it is still good to know. The PEG ratio is calculated by dividing the company’s P/E ratio by their annual EPS growth. For example, if a company has a P/E ratio of 30 and their EPS increases from .01 to .015 over a year (50% increase), the PEG ratio would be .6. The lower the PEG ratio, the better.

I rarely use the PEG ratio by itself so I’m not going to go too much into it, but I do account for growth in other ways.

Plugging in Numbers: Accounting for Future Catalysts

The best way to account for growth and factor it into a stock’s fair value is by running some calculations based on the P/E formula.

For example, let’s say a company has the following stats:

Outstanding Shares: 100 million

Price Per Share = $0.05

Earnings Per Share = $0.01

Price/Earnings = 5

Let’s assume that this particular stock is at fair value right now, but there is talk of a big deal in the works. This big deal will bring in an additional $50 million in net profit over the year if it is finalized. We can use the above information to determine how much the stock price should run up accordingly.

Net Profit Added by New Deal = $50 million

Outstanding Shares = 100 million

EPS = Net Profit / Outstanding Shares

Value added to EPS from deal = $50 million / 100 million shares

NEW EPS = $0.50

Plug that back into the fair value P/E formula. We agreed that this stock was at fair value when the P/E ratio was 5 so:

5 = Price Per Share / $0.50

Price Per Share = $2.5

We can conclude that this $50 million deal would add $2.50 in value to each share of the stock, so the stock could technically run from it’s original price of $0.05/share to the adjusted price of $2.55.

You can run these calculation for all types of operating activities. It’s great for understanding the fundamental implications of new deals, and it can also be used to account for basic profit growth due to operations. If you believe that a company’s EPS will double next year, run the calculation using that EPS and find out what a fair price for the stock will be.

In Conclusion

There is no definitive way to value a company, however, you should create a system that works for you. Every investor uses different valuation methods and will draw different conclusion accordingly. This system works for me and has allowed me to discover sub-penny stocks that run over 1000% with time.

Remember, this is just a framework to help you better understand a company’s current value compared to its fair value. The numbers won’t be exact but they don’t need to be. You are trying to draw a simple conclusion about whether or not a company is undervalued. You do not want to say a stock will go up 400% because that is its fair value based on P/E calculations. That being said, if a stock can run 400% before reaching its fair value, its probably a good investment. Even if it only runs 200%, you end up well-off. It’s also important to keep in mind that the market may never realize a company’s true value. A company can stay undervalued for a very long time. Just because they are undervalued does not mean they will reach their fair value. You will want to look at other factors such as volume, hype, etc to determine if the company has the potential to reach its fair value.

It is important to run these calculations for every stock you invest in. They don’t matter if you are trading a stock or playing the charts, however, if you truly believe in a company, run these calculations to see where it stands.

6 Things That Every Decent Penny Stock Company Should Have

May 15, 2014 | Fundamental Analysis, Penny Stock Tips

Trying to find good companies in the world of penny stocks is no easy task. Most of the companies are complete junk, as reflected by their share prices. That being said, there are some diamonds in the rough. It’s important to look at how a company operates their business in order to understand where they are headed. Sure, some people only care about charts and technical indicators, however, if you want to find some solid companies that you actually believe in, you must also focus on a company’s fundamentals. After all, it’s the people behind a company that will make or break its success. This article is geared towards people who invest in companies and don’t just trade them.

There are so many penny stock companies trading on the public markets so every investor has the luxury of being able to choose which companies they want to support. Remember, it is your choice as to whether or not you want to exercise your right to that luxury. If you cannot find any good companies, you do not need to buy anything. You’re never forced into buying a bad company. Be careful of buying into the hype and believing a company’s story. You need to be critical of everything and you need to be meticulous with your research.

A lot of people fool themselves into believing that penny stocks are companies in growth stages, and, therefore these companies do not need to be held to the same standards of other companies because they are just starting off. That theory is partially valid and partially flawed. Penny stocks are companies in growth stages, however, that does not excuse them from failing to meet average business standards. There are certain bare essentials that every company should have. As an owner of a few businesses, I always look for these things. I could start a company tomorrow with limited funding and take care of most of them, so a company who is receiving a lot of money from the public should be able to do the same.

Here are the bare essentials:

A Professional Website and Web Presence – In this day and age, if you do not have a website, you are a laggard: simple as that. There is absolutely no excuse for not having a website in this era of business. Websites can be done in-house by those with the proper skills or outsourced to the appropriate parties. Websites are relatively inexpensive nowadays as well. You can get a professional looking website designed for around $2,000-$10,000 depending on your company’s needs and resources. Sometimes, you can even get a site designed for cheaper (or free if you have the skills to do it yourself). A company website is a digital representation of a business and everything it stands for. Websites provide an opportunity for companies to present themselves as they wish to be seen. This gives investors a credible source for gaining insight into a company. Investors can learn about a company straight from the source instead of relying on 3rd party information that can be false, misleading, or damaging to a company. Of course, having a website is not just about “having” a website. A website is a tool and it should be used properly. This means that the website should look professional, provide all necessary information to investors, and build a strong brand identity. Additionally, a company should make sure that their website can be found. If an investor Google’s a company’s name, they should be able to get to the website right away. If you’re website is not up to par or can’t be found, it is a bad reflection on your company.

In short, a business should have a professional website and make sure it depicts the company as it wishes to be seen.

Revenues – Businesses are designed to make money. The only way to do that is by…you guessed it…actually making money! Revenues are essential for most real companies. There are some exceptions to this, such as biotech companies, however, most other companies should be making money. At the very least, a company should not be accumulating debt before they are making money. You can approach this on a case-by-case basis to analyze whether or not you think the company should be making money yet, however, you shouldn’t be lenient with your analysis. Revenue generation is not very difficult. Maintaining a positive net income can take time, however, revenues are the main source of cash flow and should be a priority for any company. This is huge for companies that sell tangible products. If you have tangible products, you need to have revenues or else you have failed at your business plan. If a company cannot even sell their product, you have to wonder how skilled the management team really is. I’m not saying that every company needs to be bringing in millions of dollars right away, but you should focus on how many of their products are actually being sold. For example, if a company sells e-cigarettes (a growing industry) to generate revenues, you will want to see that they are selling enough units to prove that they may have potential for growth. If their quarterly revenue is $2000 and each e-cigarette sells for $50, you can conclude that the company sold 40 units. That’s not very impressive at all. Don’t you think you could sell 40 e-cigarettes on your own in 3 months if it was your only job and you were given funds to support your efforts?  Great products mean nothing in the hyper-competitive business markets. The companies with solid sales skills are the ones that will last. Additionally, you should see how much cash a company has saved up. A lot of penny stocks only have a few thousand or a few hundred dollars in the bank. That’s embarrassing. A multimillion dollar company shouldn’t have less money than most people have in their personal bank account. Remember, when investors buy stock, they are giving the company money to finance their business activities. How well the company handles this money says a lot about them.

In short, real businesses make money and manage their finances appropriately.

Investor Relations/Updates – When a small penny stock company decides to go public, they are essentially asking a favor from investors. They are asking that investors believe in the company’s business model and provide financing to help them grow. In order for this setup to work, there needs to be reciprocation. The company who asks for money is now indebted to these investors (not legally, but for the sake of maintaining the relationship). This means that the company needs to update investors on the company’s operations. Think about it, if you lent a friend a good sum of money to start a business, wouldn’t you want some updates as to how the money is being spent? I know I would. It’s the only way to know that your money is going to good use. A company doesn’t need an entire investor relations department, however, they need a plan to keep investors updated. The business world is fast-paced and any solid company in a growth phase should have updates on a regular basis. These updates, positive or negative, need to be shared with investors. It’s easy enough to put out frequent press releases to keep your investors happy. After all, investors are the ones financing a company’s operations. There’s no need to distribute a bunch of “fluff” news that has no meaning, however, if a company can’t come up with important updates on a regular basis, there is a good chance that they are not growing as fast as they should be. Different companies will produce updates at different paces, so it’s up to you to decide if the updates are sufficient, however, if a company doesn’t update its shareholders at least once a month, I would stay away from them.

In short, a company should keep investors updates so that investors know what their money is being used for.

Business Focus/Core Competencies – When investing in a company, it’s important to know about their core business model. You should know the company’s plan and where they currently stand in their industry. This allows you to analyze the company from a business perspective. For example, if a company produces office equipment, you should hone in on every aspect of their strategy. How do they differentiate themselves? Do they have better supplier for higher profit margins? Is there a higher demand for their products over others? How many competitors do they have? Where do they stand when compared to the competition? Are they in a profitable industry? Asking these kinds of questions helps you understand the long term sustainability of a company’s business model. A solid company should know their core competencies and make them known to the public. Some companies are innovators, some companies are price leaders, some companies dominate international markets, etc. There are a lot of gaps in the markets so a company should know where they stand and have a solid plan for the future. When you see companies who try to “diversify” by entering many different industries, you can assume there is a lack of focus within their business. This became very apparent during the marijuana stock boom as all different types of companies, from aviation to surf gear, tried to position themselves in the marijuana industry. Good businesses (like good traders) know what they are good at and they stick to it.

In short, make sure you know exactly what a company does and how effective they are at doing it.

A solid management team – Having a solid management team is crucial to the success of a company. A company is only as good as the people running it. There is a reason why certain individuals are known for consistently creating successful companies. For example, if Mark Cuban backs a company, you may assume that there’s a good chance it will be successful. It is important to learn who is running a company because they control everything that the company does. Look at who the key players are within a company and do some research on them. Are they a reputed individual? Do they have a track record of success? Do they have any skeletons in their closet? Answering these questions helps you understand how a company is run and may also make you more confident in the direction a company is headed. Think about it, if someone you didn’t know asked you to invest in their company, would you? Hopefully you answered, “no.” You wouldn’t trust a stranger to handle your hard earned money. Apply that same logic with penny stocks and you will be better off.

In short, know who the key players are in a company and learn their history so you know who is handling your investment.

A Marketing Plan – As mentioned multiple times throughout this article, a company’s product does not matter. So many people forget that. Think about how many great products are out there (and those are just the ones you know of). I could have the next greatest invention sitting right next to me right now, but that wouldn’t matter if the masses didn’t know what it was, how it will help them, and how they can get it. For a company to be successful, they need a solid marketing plan. This plan dictates how a company will actually sell their product and start profiting, which, of course, is the basis for any solid business. Marketing has changed a lot in the past decade, and small start up companies can now compete with larger, well-established companies. Just look at a company like Dollar Shave Club (not public). They produced a viral video and now they’re giving bigger razor companies a run for their money. Marketing doesn’t need to be expensive. Creativity and innovation go a lot farther than big budgets these days. As a business owner and digital marketer, I see this first hand. Not every business is going to market their products the same way and not all businesses will need the same amount of marketing. That being said, a quality marketing plan is crucial and says a lot about a company’s management team.

In short, every business needs to have a plan for how they are going to get their products into the hands of the consumers they are targeting.

Runner Ups

These are a few things that can be the difference between a good company and a great company.

Social Media Pages – Social media is huge for businesses. If you need convincing of that, go do some research. Companies that find a way to utilize social media effectively will have an advantage over their competition. Similar to a website, the key here is doing things “right.” Utilizing social media just for the sake of it is a waste of time.

Stock Volume and Value– A good penny stock company will realize that there stock is actually a product in itself. After all, the company is trying to sell shares to investors. A solid company will realize that they need to catch the attention of investors if they ever want to grow their company. I have traded a lot of great companies that never reach their fair value due to a lack of volume. Trading volume reflects investors’ interest in a company. This relates to the marketing plan mentioned above. Having the greatest company in the world means nothing unless investors are aware of/interested in it. This doesn’t mean that a company should go pay for promotions or engage in other shady tactics, however, they should be trying to get the attention of investors. Chances are, if the company does everything mentioned above, the stock volume will come naturally, but if it doesn’t, a new plan may need to be formulated.

Consistency – Public companies shouldn’t be unpredictable. Investors don’t want to put their money into a company that isn’t consistent. Consistency contributes to transparency, and can improve investors’ confidence in a company. Of course, a company will always encounter surprises, however, those surprises should be related to uncontrollable external conditions, which is normal. When I refer to consistency, I am talking about how a company handles themselves. If you create a habit of putting out a press release twice a month, you should remain consistent. If you create a social media page to communicate with your investors, you should be consistent in your post frequency and responses. When a company stops doing something that investors expect them to do, it can worry investors and the share price will be affected accordingly.

Noticeable Growth – Investors want to see growth of a stock’s share price and growth of the actual business. The two are correlated. If a stock price shoots up 100% and the company reports negative business growth, investors will be skeptical. Penny stock investors base a large part of their strategy around finding growing companies at the ground floor. After all, why else would anyone buy and hold a sub-penny stock? Companies need to make sure they are growing at a rate that will satisfy investors. This can be anything from expanding a management team, extending product lines, or simply selling more product. Growth doesn’t always have to be in the financials, however, a company’s growth should be noticeable. If you gave someone millions of dollars to start a brand new company (similar to how investors give their money to penny stock companies), wouldn’t you expect them to be making noticeable progress on a regular basis? If they weren’t, you would probably be upset. You should apply the same logic to the companies you invest in.