Some people only look at the current prices of stocks and choose whether to invest or not. While the price is important, it is not the only item of importance. Unfortunately, investing in low priced stocks just because they are low is not a good idea.
In this article, we will go over how penny stock prices can be misleading and how to make an informed decision on which ones to choose for investment.
What is a penny stock?
A penny stock will usually trade for less than $5 per share. The market capitalization is almost always less than $300 million.
A low starting price potentially opens the stock up to large swings in value. SEC Rule 612 says stocks under $1.00 can increment by $0.0001, while stocks over $1.00 can only increment by $0.01. Remember that the price could be $0.001, which seems very attractive for buying because the price can’t fall much further. However, with the $0.0001 minimum tick size, the minimum movement is 10% – your investment must go up or down at least 10%. As another example, a $0.01 movement doesn’t seem like much, but when your starting price is $0.05, that’s 20%! Finally, the price can still go to zero from $0.05 or $0.001, losing 100% of your investment.
Market cap and enterprise value
The market cap and the enterprise value are more important than price when deciding which stocks or cryptocurrencies to invest in. If you need an intro to market cap, watch our short illustrative video.
If the cap is lower, there is more room for growth. However, not all stocks and markets have room for growth due to competition and a variety of other factors, including regulatory hurdles. For companies in commodified markets (i.e., where their product or service is easy to replicate and any one firm can be swapped with another), the ability to grow from micro market-cap to large may be limited.
Moreover, penny stock companies are often tiny and have limited influence or carry considerable debt. They simply may not have the market clout or economies of scale for efficiency that larger companies do. Furthermore, listed companies that have become penny stocks may have shrunken recently or have high debt burdens.
On the topic of debt, you will need to check the enterprise value against market cap, especially if your investment is an acquisition target. Enterprise value takes into account the debt a company carries, and an acquisition to avoid bankruptcy might seem awesome until you realise the entire acquisition amount covers only debt, leaving equity holders (i.e., stock investors) with no equity. Conversely, if the company you’re looking at acquired another company, the debt structure may have changed and will be reflected in enterprise value.
Enterprise value helps you to identify an extra weakness that may be obscured by the standard market cap before deciding on whether to buy shares.
Calculate the enterprise value by adding a corporations’ market capitalization, preferred stock, and outstanding debt together. Then subtract the cash found on the balance sheet. To get a better understanding of enterprise value, read our take on the GM, Ford, and Tesla debate a couple years ago when Tesla was coming up strong.
How do large cap companies get low prices?
Large companies can often get low stock prices through splits or large floats. A $0.50 stock price seems like it could 10x to $5 easily, but if there are already 5 billion shares, the market cap is $0.50 * 5b = $2.5 billion. Going from $2.5 to $25 billion in value is no easy task.
A stock split can increase the number of shares to current shareholders (thus the float) by multiplying the number of shares and reducing the price. This makes the prices more available to small investors. For example, if a $1000 investment originally owns 5 shares at $200/share, a 4:1 split keeps the original $1000 investment but represents it as 4*5 = 20 shares at $50/share. This brings down the share price by 75%. Now one share is in reach of far more people.
An Example – Apple
Apple’s stocks have split five times since the company went public. It has been split on a 2-for-1 basis three times. It has also been split on a 7-for 1 basis and most recently, a 4-for-1 basis.
This has made prices more affordable for small investors and has allowed current shareholders to get even more shares to hold onto. You can pick up a share of Apple for about $130 rather than thousands of dollars.
A Counterexample – Berkshire Hathaway
On the other hand, this popular stock by CEO Warren Buffett has never allowed for a stock split. This may benefit some aspects of the market, and there is a certain psychology at play for investors who hold or can afford Berkshire stock, akin to luxury goods pricing high even if sales volume is low. However, small investors probably won’t ever be able to attain Class A shares in Berkshire Hathaway.
If you are looking into investing, or even just living in the current year, cryptocurrency has probably been on your radar. There are many low-priced cryptos like Doge, Stellar, Shiba Inu, and HBAR. They are cheap and usually have a relatively low market cap, though exceptions to low market cap (like Doge) exist, which underlines the importance of looking not solely at price.
With the mainstream adoption process, the crypto market cap has doubled in three months (and then halved again before we could finish this article – it’s a volatile place). This includes Bitcoin and Ethereum from February to May 2021. This is a good example of how small initial market caps can grow phenomenally.
When Bitcoin first started, anyone could buy into it. However, now people are looking to the smaller cryptos because whole undivided Bitcoins are no longer affordable for most small investors. And while tiny fractions of Bitcoin are traded with ease, the growing market cap makes some wary that its intrinsic value cannot grow much more.
Some cryptocurrencies also have maximum supplies. This means there is a cap on how many coins can be mined/minted. Once that number is reached, no new coins will be produced or sold, but they will be tradeable. This restriction does point to increasing prices as demand pressure builds but supply cannot change. Bitcoin’s max supply is about 21 million, while XRP’s max supply is 100 billion, so it is important to check your specific investment target, as these caps can range widely.
For this reason, XRP will remain lower-priced than BTC, at least in the near future. Even if Bitcoin’s and XRP’s market caps were the same, there are 5000 times more XRP coins and thus 1 XRP would cost 1/5000th of 1 BTC. For XRP and BTC to have the same price, the XRP market cap would have to be 5000x that of Bitcoin’s, a tall order for the near future at least.
Regular stocks do not have maximum limits. The company can always issue more shares or divide the shares in splits as needed (also increasing the number of shares). However, most companies try to limit these procedures because splitting often can lead to excessively low prices and constant issue of shares dilutes current shareholders’ investment value (upsetting the existing investors).
Other problems with penny stocks
We’ve gone over what to look for in penny stocks and some caveats around market cap and enterprise value. Let’s go over a few other key issues that should affect your investment decision.
There are usually very low trading volumes when they first hit the market, which creates low liquidity. This can also cause very large swings in the price of the shares because rapid selling can greatly impact the price of shares. Conversely, an order to buy a large amount could push the price up long before your order is filled completely. Use limit orders on penny stock purchases and sales.
Much like when people check your credit score or spending history, you should also be checking a company’s history before investing. Penny stocks usually don’t have a proven track record yet, which makes due diligence harder and investing riskier.
Public information is limited
Companies that are trading over the counter with the OTC Bulletin Board or through pink sheets don’t have to file with regulatory bodies. So, it can be extremely hard to find reputable information before you decide to buy. They also don’t have to meet minimum listing requirements as larger stocks do.
Companies that have filed with the SEC will have an OB suffix attached to them and have more public information available to you but it can still be limited. Keep in mind too that the published history may not be very long.
Publicly available news and even social media content surrounding some of the smaller companies may also be thinly available. With 12,000 sources and tens of thousands of private companies covered, CityFALCON can help you track whatever there is to track, even for penny stocks. SEC and LSE filings are also available, like the 10-K, which may be the only data available for low-profile companies. You can even track prices with our charting tools. Get started with a penny stock watchlist:
The Current Price Range
One more important point to note is that price inflation may be in play, as central banks flooded the money supply with new currency to assist the recovery from the pandemic. There are many more people in the stock market, now, too, thanks to the proliferation of low-cost trading apps, bringing their own capital into the markets. This may be a major driving force behind the bull market runup in the past year.
Penny stocks, even with their very low prices, can still go to zero, and a crash in the market could be that trigger. Protect yourself by understanding how FOMO and behavioural finance can cause costly mistakes, including at the tiny-cap level.
Overall, the low prices of penny stocks can be appealing for a new or limited investor. The lack of information about them and the large swing potential though can make it a poor investment. Do not be deceived by low stock prices, which can hide huge floats or large debts without proper due diligence.
Before investing, make sure your targets have potential growth and look at any debts they have acquired. Determine what you think the true entire value of the company is, then look at the market cap and determine if it is lower than your expected value.