Many of the traditional metrics to value stocks simply don’t apply to early-stage companies. That doesn’t make them bad companies — it just means you have to value them differently.
Early-stage companies often offer shareholders the opportunity to buy into a particular sector, either established or emerging, for a lesser price and potentially larger upside.
Generally speaking, small-cap stocks are more volatile than larger more established businesses – this can often lead to much larger share price movements.
For instance, a junior miner gaining 20 percent in the space of a week on a promising drill hit isn’t all that uncommon — but the likes of Rio Tinto doing that would create huge headlines.
Small cap companies are often created to pursue one project, or sell one product — meaning success or failure in doing so has the potential to dramatically move the needle on their share price.
This makes getting a read on how to value them a little bit more tricky — as there’s simply not a lot of data to go on.
A lot of companies can also be pre-profit, pre-dividend, or even pre-revenue. So traditional metrics for measuring these companies, such as a price-to-earnings ratio or dividend yield, simply don’t apply.
Even using a revenue multiple can be wildly misleading – particularly when the company is in the early stages of commercialisation.
For example, a company could have a market capitalisation of $30 million but only generate $1 million in annual revenue – putting it on a revenue multiple of 30x. Which would be high in any sector.
However, there is a lot more at play. The company may have invested $10 building the business’ technology or manufacturing its products. And then there is the intellectual property, good-will and established relationships and supply chains that company has.
So is there a way to simply value a small-cap stock? There are a few ways, but they don’t all apply to all small-cap companies.
What makes covering small cap companies so interesting is that no two businesses are alike – so it can be hard to prognosticate where they’re going.
Here are five common things to look for when choosing and valuing a stock.
5 ways to evaluate a small-cap stock
Board and management
It’s usually important to take into account the board and management in any company, but in small and micro-cap stocks it’s even more important.
Larger companies have multiple business units generating value (and hopefully revenue), but in smaller companies management is usually tight.
So, it’s best to look into the background of people on the board and management.
Do they have experience in driving value for small companies and potentially turning them into multi-baggers? Do they have deep sector experience? Do they have good capital markets contacts?
Are key players incentivised to succeed?
Options, depending on how many are out and how they’re priced, can be a good thing to look for when evaluating whether to invest in a smaller company.
READ: What are derivatives?
If options are aggressively priced against a company’s current share price and they vest in the nearer-term (one to two years instead of five or six years), it could be a very good thing.
If they’re a 50 percent improvement on the current price and vest in two years for instance, the board has to work really hard to grab those options at a price which makes them attractive.
Conversely, if they’re priced at a 5 percent increase and vest in three years, management won’t need to drive all that hard to pick up a bargain.
Of course, you should also look at the amount of shares out on issue to figure out whether the options out are ultra-dilutionary in effect.
Are they funded and how much capital have they raised to date?
When looking at a resource exploration company for instance, knowing how much money they have on hand can be key.
If it’s fully-funded for one to two years’ worth of exploration activity, there’s little likelihood that it’ll need to tap the market in the near-term for extra funding.
Alternatively, if it’s short on cash and the ASX is asking it how it’ll fund the next quarter’s activities you can be pretty sure it will be going to the market ‘cap in hand’ soon — and therefore diluting the value of any shares you may pick up.
What traction is the company likely to achieve in the near-term?
One of the key indicators of a company’s future prospects is what agreements, deals, partnerships or contracts does it have in place that are likely to generate future earnings.
Perhaps the company has just signed a major distribution deal with a leading retailer. This could be a positive indicator that there is a demand in the market for its products or services and having access to an established distribution channel could help to boost sales.
None of this would be a given, but without historical sales data to base any expected future sales on, the ability of a company to land a big distribution deal can be a good indicator of how successful its sales strategy will be.
What sector are they operating in and how big is the opportunity?
A lot of people invest in companies on the market purely because they want exposure to a particular sector which may be difficult to invest in otherwise.
For example, they may invest in a company like Security Matters (ASX:SMX) because they want exposure to the blockchain tech sector.
Meanwhile, they may invest in Xanadu Mines (ASX:XAM) because they want a more pure exposure to Mongolia than they may get from investing in Rio Tinto.
One of the most important points to consider here is, how big is the opportunity and how many others are competing for a slice of the pie.
If the opportunity is significant and there is only one company going after it perhaps it’s good investment, or perhaps no one else is going after it for a reason. This may come down to a matter of opinion or how well you know the market.
Whatever your fancy is, you can choose a company which has exposure to what you see as a growth sector.
Think gold is going up? Look at a gold company. Excited by the potential of e-sports? Go look at a company with an e-sports play.
Star Investing may have commercial relationships with companies mentioned in this article. This content does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions
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