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:

Quarter 1:Revenue: $1 millionProfit: $800,000 (80% margin)

Cash: $1 million

Quarter 2Revenue: $2 millionProfit: $1.2 million (60% margin)

Cash: $500,000

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.