The Importance of Share Prices for Penny Stock Investors

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Is there such a thing as a $100 penny stock? You bet!

In the penny stock world, share prices get a whole lot of attention. Significantly more than they should. And that misguided emphasis on share price could end up costing you a lot of money. Today, we’ll take a look at how share prices are set, how they can be manipulated, and the metric you should really be looking at to determine whether an investment fits the penny stock mold…

It’s not surprising that so much emphasis is put on penny stocks ’ share prices – after all, the name “penny stock” implies that shares trade for pennies. But that’s not really the case at all.

Keep in mind that people have been investing in penny stocks for more than 100 years – 100 inflation-riddled years. So basing an investment’s definition on an unchanging unit of currency doesn’t make a whole lot of sense.

After all, a stock that cost just 50 cents per share back when Charles Dow created the Dow Jones Industrial Average in 1896 would cost an inflation-adjusted $12.93 today. That means the stocks that trade for pennies today would have been worth infinitesimally small per-share values decades ago – and that’s for good reason.

You see, companies have significant control over their own share prices. That’s because they control the number of shares they issue. What they can’t easily control is their total value, or market capitalization. When a company wants to lower its share price, all it has to do is split shares – in effect, they’re cutting up their market capitalization into more pieces that represent smaller ownership.

It’s a move that makes no difference to shareholders (the total dollar value of their shares doesn’t change in a split, they just end up with more shares that are worth less), but it can make a difference to investors who are lured by “cheap” share prices alone.

Worse still, a company can also issue new shares, diluting their share prices and current shareholders’ ownership stakes to raise capital. For companies with weak balance sheets and a need for additional cash, dilutive share issues are one of the easiest ways to raise capital.

It’s not uncommon to see shares of these kinds of stocks trade for pennies – they’re diluting the value of their shares down to nothing!

Of course, not all sub-$1 are inherently “bad”, but it’s obvious that share price is pretty worthless as a determining factor of an investment’s attractiveness. Clearly, there’s got to be a better way to go about investing in penny stocks…

Spotting Gain Potential in Penny Stocks

Here at the Penny Sleuth. we’ve long said that penny stocks are one of the most attractive assets to pursue. They lead the way out of recessions. And they historically deliver outsized gains when compared to their blue chip peers.

But share price isn’t the key to defining a penny stock… Market cap is.

Remember, market capitalization (also known as market cap) is the total value of a company. If you’re looking to invest in small stocks with large growth potential, it makes a whole lot of sense to use market cap as your defining metric. Generally, we like to relegate our searches for penny stocks to those with market caps under $2 billion. This is the textbook definition of a “small cap” stock.

All small caps have very similar trading and price characteristics, regardless of the share price they trade for.

What to Focus on as an Investor

It’s crucial to think of gains in percentage terms – a 25% gain on 500 shares of a $1 stock is exactly the same as a 25% gain on 5 shares of a $100 stock. In both cases, your gains are a function of the total position size and the gain percentage – share price is completely irrelevant.

All too often, our mailbag here at the Penny Sleuth is filled with questions from readers who want to know why we’re talking about a $10 or $15 small cap stock when we’re supposed to be a penny stock e-letter. But that’s a dangerous way of thinking that could cost you serious missed opportunities and expose you to the worst stocks on the market.

Instead, it’s best to think of penny stocks as small companies, not companies with small share prices. Keep your eye on market cap if you want to reel in penny stock gains in 2011.