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How to Evaluate Penny Stocks

  • By Jenna Gleespen
  • Sep 15, 2022
How to Evaluate Penny Stocks?

You might have heard of people making millions off penny stocks, while others share stories about losing their entire investment. If you are looking to learn how to evaluate penny stocks to pick out a winner, check out our complete breakdown.

Table of Contents show

How Do You Know If a Penny Stock Is Good?

You can never know if a penny stock is good for sure. But there are several factors that you should monitor to determine if one has potential.

A great place to start is scouting for companies with solid fundamentals.

Examine profit margins, cashflows, sales pipeline, debt, the possibility of a buyout, industry growth, and so on.

You should also understand what stage the industry or the stock is currently in. Is it a mature industry or a new sector with many competing startups?

how to evaluate penny stocks

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A Bit About Trading Penny Stocks

Some of the most popular penny stocks belong to small companies from high potential and risky sectors like tech or biotech. Oftentimes, these companies do not have a proven track record and little or no actual revenue.

Biotech and tech aren’t the only names in the game, though. Other common penny stocks include mining, precious metals, oil and energy, and more.

Regardless of the sector, a crucial skill to hone is market timing.

Sectors can experience huge spurts when the market starts to focus on them. A common example is the dot-com bubble and the resulting bust in the 90s.

You will need to be mindful of timing your exits, as a drop-off often follows growth spurts. Some companies might make it through and carry the momentum, but many more will be left behind.

Another aspect to look at is whether a stock is in a make-or-break sector. Typically, these businesses are resource-intensive, such as biotech or renewable energy.

They are risky investments because the outcomes are often all or nothing and dependent on external factors rather than whether the company makes money.

You could earn massive profits. However, the downside is that you could lose everything that you invested if the sector doesn’t pan out or if a regulatory change occurs.

how to evaluate penny stocks

What Should I Look for When Picking Penny Stocks?

Apart from fundamental analysis, it is critical to keep an eye on market indicators such as the P/E ratio, stock volatility, market capitalization volume, and float.

Another significant factor to consider when choosing penny stock companies is their management and credentials.

Lastly, most penny stocks can see huge price movements during catalyst events such as regulatory changes, a buyout or M&A activity, or even a solid quarterly results performance.

It is important to keep track of all these indicators when trying to pick winning penny stocks.

P/E Ratio

The price-to-earnings ratio is what many traders use to gauge a stock’s value.

The P/E ratio is determined by dividing the price of a stock by a company’s earnings per share. What constitutes a good P/E ratio depends on the industry.

Furthermore, a high P/E ratio does not necessarily mean that a company should not be considered — this metric just provides a helpful guideline.

how to evaluate penny stocks

Many investors knowingly invest in stocks with a high P/E ratio because they believe that the stock has significant potential down the road. Tesla is an example of a stock with a high P/E ratio that investors are more than happy to back because of its future prospects.

Some penny stocks represent companies that do not have any sales or are currently in the red. In this case, the P/E ratio is not the most appropriate metric.

Some alternatives are price-to-sales ratio or price-to-cash-flow ratio.

Volatility

Volatility is a measure of how much a stock’s price fluctuates. Mathematically, it is the standard deviation of a stock price over a given time period.

High volatility means that the stock price moves around a lot, which, in most cases, also means that the stock is riskier.

Some investors target volatile stocks to capitalize on quick price movements.

how to evaluate penny stocks

Catalysts

A catalyst is an event that can precipitate huge movements in stock prices — up or down.

Here are some examples of catalysts:

  • The company reported a favorable/unfavorable quarter
  • Announced a new product
  • Legal changes that impacted the company
  • M&A activity or the possibility of a buyout
  • Revision of growth projections from analysts

Often, penny stock companies do not have strong investor reporting.

Therefore, keeping an eye on positive versus negative catalysts is critical when trading penny stocks.

Good Management

One more sign that anyone investing in penny stocks should always look at is the company’s management. Some questions to think about include:

  1. What are their credentials and past performance?
  2. How sound are their corporate governance norms?
  3. How clear and open are they about plans?
  4. How precise is the company’s vision?
  5. How well do they follow through on promises made in investor calls?

Strong management is the backbone of a growing business, so a penny stock company with capable management has a better chance of moving up.

Volume

Stock volume is the total number of stocks that are being bought or sold in a given time period. It is an indicator of how many investors are interested in a stock.

Penny stocks are typically low-volume stocks. However, what’s important is keeping tabs on changes in volume.

A consistent, upward rise in trading volume (rather than a sudden increase) indicates that investors are interested in the stock.

how to evaluate penny stocks

Float

Stock float is the total number of stocks available for public investors to trade in.

The higher the float, the less likely it is for a single person or group of traders to influence the price of a penny stock.

Penny stocks often have a low float, especially if they trade over the counter. Avoid such stocks because they are easier to manipulate by a small group of investors.

What’s the Highest a Penny Stock Can Go?

There is no limit to how high a penny stock can climb.

Often, penny stocks are shares of startups, which are just looking to raise money to fund their ideas.

If the idea pans out, penny stock prices can shoot through the roof. But at the same time, many startup ideas fail, so the stock can fall as well.

Still, Apple, Amazon, and other huge companies traded at less than $5 at one time.

These aren’t typical, and you shouldn’t jump into any penny stock anticipating it could be the next Amazon or Apple.

how to evaluate penny stocks

How Do Beginners Invest in Penny Stocks?

As mentioned, beginners should avoid buying penny stocks that trade on over-the-counter (OTC) markets. Instead, focus first on stocks that trade on a major stock exchange.

This can bring the risk down quite a bit, but there’s always a chance to lose an entire investment — especially with penny stocks.

But why are stocks listed on major exchanges considered safer?

Major exchanges have safety precautions that don’t let low-quality stocks survive for long.

Also, stocks trading on publicly listed exchanges such as NASDAQ and NYSE have to follow stricter financial standards for compliance and reporting.

These stocks are less susceptible to manipulation and fraud, and share prices are more difficult to manipulate because the trading volumes are typically much higher.

A convenient option to buy penny stocks is through online brokers, such as Robinhood and Webull.

how to evaluate penny stocks

These brokers let you buy penny stocks listed on major stock exchanges, which often have built-in protections for investors.

Moreover, trading penny stocks through these online brokers is much more accessible than buying or selling from the OTC market.

How to Choose Penny Stocks for Day Trading

Day trading penny stocks requires careful evaluation and serious due diligence.

We’re going to stress again that a general rule for newbies is to steer clear of pink sheets and OTC stocks.

You can trade on pink sheets once you get acclimated to penny stocks. However, there are just too many pitfalls for fresh faces on the stock market to stumble into. 

Secondly, be mindful of investments with higher trading volume. Day traders hold positions for minutes to hours. So it’s wise to invest in stocks that you can quickly sell if needed.

When a catalyst such as a positive quarterly result or other news breaks, trading volume can skyrocket due to an increase in buying pressure.

Keep an eye out for stocks that have such catalyst events coming up, and try to maximize potential on such days.

Lastly, stay away from penny stocks that are receiving too much promotion online as being the next big thing.

More often than not, such stocks are being promoted not because market investors find value in them. Instead, the owners are simply looking to jack up prices and then exit at a high.

The truth is, it is unlikely that the next Amazon is being traded in the penny stock market. Most big entries today happen through initial public offerings (IPOs), where the prices are much higher than $5.

If you buy penny stocks based on these kinds of promises, you might lose a lot of money.

Is It Hard to Sell Penny Stocks?

It can be difficult to sell penny stocks when the trading volume is low.

If the volume is low, there may not be any buyers for the stock, so you might end up having to lower the selling price.

Moreover, a lack of trading volume makes it easy for unscrupulous market makers to use techniques that manipulate the stock price.

Should You Invest in Penny Stocks?

You should only consider investing in penny stocks if you have a high risk tolerance — even then, there may be safer options.

Penny stocks are high-risk investments.

Their biggest draw is exponential growth because the price is so low that even a slight increase or decrease is huge in percentage terms.

Unfortunately, due to low trading volume and liquidity, these stocks are often easy to manipulate and can be hotbeds for fraud.

That does not mean all penny stocks are worthless. But it also means that you need to be doubly vigilant and do more rigorous analysis before investing in penny stocks.

how to evaluate penny stocks

Penny stocks trade at very low prices with a possibility for exponential growth with even small price movements.

New investors are often enamored by the possibility of huge gains by investing just a small amount in penny stocks.

Unfortunately, many penny stocks are also highly volatile, thinly traded, and subject to fraud and deception by market makers.

Make sure you choose the right penny stocks after having thoroughly analyzed the company’s fundamentals and track record.

Moreover, pick stocks that have higher trading volumes and float and are listed on major stock exchanges.

Start investing in penny stocks with small amounts and increase your outlay as you get more confident in your analysis and the results that you get.

Paper trading is also a solid option that lets you test out strategies without risking your hard-earned cash.

New penny stocks are trading every day with huge potential for profits, so don’t worry that you are missing out on a big trade.

Lastly, it is not impossible to make money on penny stocks; it just takes time and due diligence, along with a bigger risk.

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Jenna Gleespen is a published author and copywriter specializing in personal and investment finance. Her expertise is in financial product reviews and stock market education.