Penny Stocks Are Not Cheap Stocks

By Pinyo, on May 11, 2009

A common mistake for a beginning investor is equating low price per share stocks, such as penny stocks, as inexpensive stock price. After all, it feels intuitive that a $1 stock is less expensive than a $10 stock. Unfortunately, this is the wrong way to think. The first thing you need to know about stock investing is that the share price by itself doesn’t give you enough information about its value.

Ways To Evaluate Stock Value

To gain a better understanding of a stock value, you can start by examining its fundamentals. However, there are too many ways to look at the fundamentals, so I will just introduce you to the four commonly used ones.

Photo by Africankelli via Flickr

Price-Earnings Ratio (P/E Ratio)

The first and most common way to value a stock is using the Price-Earnings Ratio, or P/E ratio. The P/E ratio is a valuation ratio that compares a company’s current share price to its earnings per share (EPS). The P/E ratio is sometimes referred to as the earnings multiple, or just multiple, because it indicates how much money investors are willing to pay for one dollar of earnings.

For example, if a company is currently trading at $25 a share and earnings over the last 12 months were $2.50 per share, the P/E ratio for the stock would be 10 ($25/$2.50). In term of multiple, this means investors are willing to pay $10 for $1 of earnings.

Usually, EPS is from the last four quarters (trailing P/E), but sometimes estimates of earnings expected in the next four quarters (projected P/E or forward P/E) or even a combination of the two methods is used by investors to perform their stock valuation.

In general, companies with a higher P/E are expected to have a higher earnings growth in the future compared to companies with a lower P/E. However, you have to be careful when comparing companies from different industries. For example, technology companies tend to have higher P/E than utilities companies, etc.

Price/Earnings To Growth (PEG Ratio)

Next is one of my favorite ratio, Price/Earnings To Growth ratio, or PEG ratio, is an improvement over P/E ratio in a sense that it also takes a company’s growth into account. Similar to the P/E ratio, a lower PEG means that the stock is more undervalued. The PEG ratio is figured by taking the P/E ratio and dividing it by the earnings growth rate. For example, if a company has a P/E ratio of 10 and a growth rate of 8% per year, its PEG ratio would be 1.25 (10/8).

However, you should note that the earnings growth rate is a projection and as such, this ratio can be less accurate.

Price/Earnings to Growth and Dividend Yield (PEGY Ratio)

This is another variation of the P/E ratio and PEG ratio that takes dividend yield into account. The PEGY ratio is figured by taking the PEG ratio and dividing it by the dividend yield. For example if a company has a PEG ratio of 1.25 and a dividend yield of 2.5%, its PEGY ratio would be 0.5 (1.25/2.5).

Again, a lower PEGY ratio is an indication that a company might be undervalued. However, you really have to be careful when using this ratio because (1) not all companies offer dividend, (2) various industries have significantly different average dividend, and (3) big price swing can seriously affect the dividend yeild since it’s a function of share price.

Price-To-Book Ratio (P/B Ratio)

The Price-To-Book ratio, or P/B ratio, compares a stock’s share price to its book value (the value of a company’s total asset according to its balance sheet). The P/B ratio is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share. For example, if a company stock price is $25 and the book value per share is $16.50, its P/B ratio would be 1.52 (25/16.5).

A lower P/B ratio means that the stock might be undervalued. In general, this ratio gives you an idea of what would be left if the company went bankrupt today.

Conclusion

Okay, I’ll stop right here instead of boring you to death with all these ratios. The point I was trying to make is that you cannot simply decide if a company is a good buy or not just by looking at its price. Hell, you can’t even tell by looking at all these ratios above, because there is a lot more due diligence that you must go through. That’s why individual investors are better off staying away from individual stocks. And for those who argue otherwise — yes, there are investors who do really well picking individual stocks, but they are exceptions, not the rule.

Pinyo is the owner of Moolanomy Personal Finance and an entrepreneur with over 20 years of business experience. He is interested in business management, investing and wealth management. He has written for many online publications, including American Express Currency and U.S. News Money. You can follow him on Facebook and Twitter.

Add Your Question or Comment (13 Comments)

1. craig:

   May 11, 2009 at 12:54 pm

   I am very new to investing and personally have no investments of my own, but looking into things. All I know about penny stocks is just that, they are cheap. But I like your explanation that in reality they are not cheap if you look at the ratios behind them, and potential growth.
2. Matt Jabs:

   May 11, 2009 at 1:43 pm

   I had a stint messing around w/penny stocks.

   In the end it proved to be a big waste of time! At least for me…
3. mupal:

   May 11, 2009 at 2:06 pm

   My friend has lost quite some money in penny stocks, I do not know any one who can consistently make money in them.
4. Writer's Coin:

   May 11, 2009 at 8:12 pm

   Great article! I was trying to say the same thing with my post called “Is a $5 Stock Cheaper than a $30 Stock?”. You seem much more relaxes about it. It drives me nuts when people make that assumption!
5. MLR:

   May 12, 2009 at 12:44 am

   Great post, seems to have done well on tip’d

   I also had a friend investing in 10 cent stocks because “all it had to do was go up 10 cents” for him to make some money.

   I asked him how he expected the stock to double in value. He didn’t seem to realize that doubling is still doubling no matter the base price.

   Meh. His lost money.
6. Sherin:

   May 12, 2009 at 9:27 am

   You are right. In my opinion, identifying the initial rate of return when buying the stock will tell whether the penny stock price is to expensive or cheap.
7. Doctor S:

   May 12, 2009 at 4:35 pm

   Thanks for identifying the basics on something I had no idea about. Its funny, back when I was in hs, my friends and I were thinking the same thing that @MLR was saying…. we wanted to be tons of stock in Worldcom b/c it was only $0.01. We told ourselves “All we need is for it to go up a few cents and we are set!” Hahahah naive youth days for me!
8. SJ:

   May 12, 2009 at 7:56 pm

   Nah penny stocks are cheap. You just aren’t getting much for your value (sometimes)…

   It’s like buying really cheap singly ply toilet paper.

   One thing to note is that usually the pricing can be manipulated more easily due to less peeps buying/selling resulting in higher volatility in price… which can be good or bad =)
9. Pinyo:

   May 13, 2009 at 10:33 am

   @Writer’s Coin – Nice article. I guess the misconception about cheap stock doesn’t bother me as much.

   @MLR – Thank you for your help on Tip’d. Good point about doubling.

   @Doctor S – Hmm…Worldcom…what’s that?

   @SJ – I tried single ply toilet paper. Not very nice.
10. Danny:

    June 4, 2009 at 4:14 am

    Only amateurs would post the above statements. Look at Sponge tech for a great penny stock that is exploding. With commercials on tv, advertising in Baseball stadiums, and a spot on the Home Shopping network, all bases are covered in advertising. Oh, they had more sales last month than the whole previous year. No wonder my money doubled.

    If you pick a product that has great advertising and great sales, how can you go wrong?
11. Pinyo:

    June 4, 2009 at 9:35 am

    @Danny – Feel free to call me amateur for having a different view than yours about Penny Stocks. By the way, did you even read my post? I said nothing about it being good or bad. I am just using it as an example on how to evaluate stock value.
12. The Happy Rock:

    June 4, 2009 at 10:21 am

    Penny stocks are pretty wretched for the most part. Full of shattered dreams and wasted capital.

    @Danny – I must say that you are the one that sounds like an amateur. There is a lot more to a successful company that advertising and sales and there are about a million ways to go wrong. From my experience the most likely scenario for your stock is to have to sell more shares to ‘expand and grow or to cover debts’ which will further dilute the share price not increase it despite growing sales.
13. Mike:

    November 2, 2009 at 7:41 am

    I am actualy giving away £10 worth of free penny shares as part of our venture to help people through the credit crunch. All genuine wealth seekers invited.