9 Essential Elements for Evaluating Small Cap Stocks

by Siddharth Singh Bhaisora

Published On July 4, 2023

In this article

We dive deep into the crucial metrics you need to consider while evaluating small-cap stocks. The wisdom imparted here could help you uncover a few hidden treasures in the small-cap market in India.

You don't need to tune into a finance TV show or a Youtube video to hear about the next big 'guaranteed' method promising to make you a millionaire overnight. Often these systems, which include technical trading systems, proprietary methodologies, complex economic models, and even astrological charting methods, are not worth your time or investment.

A fundamentally strong business that turns a profit, boasts a diverse product range, and has a secure market position is your potential golden goose. You are 90% of the way to discovering a sound investment. The remaining 10% involves looking at some specific metrics to ascertain if it's the best stock for your hard-earned money.

Let's explore these 9 key metrics you should check before buying any small cap stock. They will aid you in comprehending the company, its operations, and the underlying business.

1. Institutional Activity

Institutions such as pension funds, mutual funds, hedge funds, insurance companies, and corporations can create massive price fluctuations with their vast share transactions. To minimise this risk, aim for companies where institutional ownership is less than 40% of the shares. You can find this information on financial news platforms such as Moneycontrol, Mint, ET Money etc.

2. Analyst Coverage

The number of analysts tracking a stock can also indicate future share volatility. Analysts tend to move as a herd. When one sells, others follow, leading to large volumes of shares trading hands and typically causing price drops. It's wise to steer clear of companies with more than 10 or fewer than 2 analysts following them.

3. Price-Earnings Ratio (P/E)

The price of a share of a company divided by its earnings gives the P/E ratio, a popularly used metric in the financial markets. This ratio determines whether a company's shares are overvalued or undervalued. It's advisable to compare the current P/E of the company with its average P/E over the past 3-5 years, its estimated future P/E, and the average P/E of its industry. If the P/E exceeds 35, the shares may be too expensive, particularly for novice investors.

4. Cash Flow

The Statement of Cash Flows in a company's financial report is crucial. It summarises how the company earned and spent its money. A positive Total Cash Flow From Operating Activities figure or a trend in that direction over a year is desirable. You can find a company’s cash flow on Yahoo! Finance, Moneycontrol & other such sites. Cash flow number should be positive or trending positive over time, since if it isn’t generating sufficient cash flow from it’s primary business, then it isn’t worth your time or investment.

5. Debt/Equity

This ratio signifies the amount of debt per dollar of ownership incurred by the business. Having debt isn’t bad, it can be good to have debt on the company’s balance sheet to reduce taxes, or it can be industry specific such as infrastructure which has have high levels of debt (75%+). Examine if the company's debt level has been increasing too rapidly over the years and how it compares with its competitors and industry averages. Excess debt is a red flag and be wary of bankruptcies due to excess debt.

6. High Operating Margin

The operating profit margin indicates the percentage of profits generated from operations before taxes and interest are paid - it essentially measures the profitability of the business. A company with a consistently increasing operating profit margin can be a promising investment opportunity.

7. Rising Sales and Profits

Small cap companies usually have limited cash reserves and depend heavily on their sales. It's crucial to examine their sales and profit numbers for at least five years. A good rule of thumb is to buy shares in companies whose sales and net income are growing at double-digit rates. Generally, stock prices appreciate with growth in earnings, which usually follows the expansion of sales.

8. Quality of Management

Corporate governance and quality of management is extremely important. This is especially important for small-cap companies. Even minor management errors can have a significant impact on the price of small-cap companies. Therefore, conducting a thorough background check of the company’s promoters and management is crucial before investing.

9. Insider trading activity

Last but not least, it's crucial to observe the actions of those within the company. If the directors and senior executives of a company are buying or selling shares, it might indicate their confidence (or lack thereof) in the company's future. High levels of insider selling could be a red flag, while insider buying could suggest that the company's leaders believe the stock is undervalued. You can find information about insider transactions on several financial news and information platforms.

Stay armed with these key metrics, and you're on your way to making informed decisions about smallcap stocks. As the old saying goes, "Forewarned is forearmed!" Get investing and let your portfolio thank you!

Learn more about the trending Wright Smallcaps Portfolio . Be sure to check out the next article in this series: Risks & rewards of Investing in Smallcaps

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