Three Penny Stock Myths

MYTH NO 1: STOCKS TRADING BELOW BOOK VALUE ARE CHEAP

Book value (BV) is the actual worth of a stock as in a company’s books/balance sheet, or the cost of an asset minus accumulated depreciation. BV depends more on historical cost and depreciation and often has little correlation to the current share price.

Shares of industries that are capital intensive trade at lower price/book ratios, as they generate lower earnings. On the other hand, those business models that have more human capital will fetch higher earnings and will turade at higher price/book ratios. “Price/book (ratio) of below 1 may be cheap but one should see other aspects such as earnings forecast, guidance, management and debt on the books of the company,” says Angel Broking’s equity derivatives head Siddarth Bhamre.

MYTH NO 2: STOCKS TRADING AT LOW P/E ARE UNDER-VALUED

Price to earning ratio (P/E) is one of the most talked about ratios in the market. This is based on the theory that stocks with low P/Es are cheap. However, P/E alone doesn’t tell much about the stock price. P/E multiples may be a quick way to value a stock but one should look at this in correlation with expected growth earnings, the risk factors involved, company’s performance and growth potential. ”

This is surely a myth. It is also an indication of uncertain future earning of the stock concerned,” says Birla Sunlife Mutual Fund CEO A Balasubramanian. The idea behind dividing price with earnings is to create a levelplaying field where some kind of comparison can be made between high- and low-priced stocks. Since P/E ratios vary across sectors, with growth stocks consistently trading at higher P/E, one can only compare the P/E ratio of a stock to the average P/E ratio of stocks in that sector.

MYTH NO 3: STOCKS THAT GIVE HIGH DIVIDENDS ARE THE BEST BET

This comes from the notion that regular dividends are extra in-come in the shareholder’s hand. This may not always be true. While a company may be making decent payouts every year, the share price appreciation may not be comparatively high. Before investing in companies paying high dividends, it’s important to analyse if the company is reinvesting enough profit to grow its earnings consistently.

Says Brics Securities’ research VP Sonam Udasi: “It’s not dividend that matters but the yield. For eg, a company may pay a 100% or even a 300% dividend on a stock with face value of Rs 10. So, the investor may receive Rs 10 orRs 30 per share when the stock may be currently trading at Rs 800 or Rs 1000. This would translate into an yield of 1% or 3% only.

Also, such companies may not necessarily be reinvesting their earnings in the business to generate future earnings and so there may be no stock movement. The dividend may be high but the EPS and growth per se may be constant.”