Many investors fail to understand valuation
when they buy a growth stock.
We see it all the time: Individual investors who buy a small cap stock
based on its trading momentum and ignore the market valuation of the stock they
buy. This leads to heavy losses after the stock price peaks and then rapidly
declines. At this point, the price of the stock could take a long time to
recover (if ever) and the decision to sell becomes
emotional when your small cap investment has declined in value much below your
This is a
common mistake by small cap investors that we call: Buying a stock that is
priced for perfection.
an investor must accept that small cap stocks are almost never perfect
investments. There can be many unexpected reasons (both market- and
company-specific) that can have a dramatic impact on a small cap stock price.
To this point, small cap stocks can be very volatile and rarely behave like
reliable investments while you hold them.
why would investors buy small cap stocks that are already priced for
perfection? These "perfect" stocks trade at market valuation that
assumes the underlying company’s longer-term business plan has already been
executed. This means that the stock will need to meet and exceed all
expectations going forward all the time. Is this realistic? Not really.
novice investors purchase that small cap/microcap stock priced for perfection
based on its sexy industry, share price momentum or the fact that they heard
about the stock touted on a business television show. But before they do, they
should do one simple math calculation by figuring out the market capitalization
(the company’s current worth) of the stock they are buying.
market capitalization equals the amount of stock outstanding (or issued) by the
company multiplied by the stock’s current trading price. For example, if the
current stock price is one dollar and there are 100 million shares issued by
that company, then the market capitalization is equal to $100 million dollars.
(Note: For the purpose of this example, we will assume no outstanding warrants
or convertible debt which could alter the future valuation.)
the calculation of the market capitalization is when the reality check needs to
happen. Too often we see high-flying small cap stocks that currently have
little in annual sales (not to mention earnings) but trade at an excessive
market capitalization. If our $100 million company today has only $5 million in
annual sales, its current market valuation is 20 times that amount. A prudent
investor must consider all the variables in order for that company to achieve
that amount of future annual sales closer to its current worth, which is a big
gamble to say the least.
calculating sales to market capitalization multiples for small cap stocks, we
would encourage small cap investors to pay less than 2.5 times for that stock
price, especially for companies without earnings. We also note that buying
wisely is also buying a small cap stock from companies that have a good balance
sheet; preferably with ample cash on hand and little or no debt.
time you are inclined to buy that intriguing small cap stock, do the simple
math first. It might save you a bundle in losses or it may prove to be the
perfect time to buy!
This article is for informational purposes only. This article is based on the
author's independent analysis and judgment and does not guarantee the
information's accuracy or completeness. The information contained in this
article is subject to change without notice, and the author assumes no
responsibility to update the information contained in this article. The
information contained within this article should not be construed as offering
of investment advice. Those seeking direct investment advice, should consult a
qualified, registered, investment professional. This is not a direct or implied
solicitation to buy or sell securities. Readers are advised to conduct their
own due diligence prior to considering buying or selling any stock.