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Evaluating penny stocks requires a different lens than analysing large-cap companies. These are often early-stage or smaller firms with limited brand recognition, less access to traditional financing, and financials that may not look attractive on the surface.
So using the tried-and-tested valuation metrics that work on FTSE 100 stocks may not be as effective.
Here are a few tips to follow when trying to assess whether a penny stock could be a sound investment.
Cash is king
Check the company’s free cash flow (FCF). This is how it funds operations and growth without resorting to dilutive share offerings or expensive loans. Even if it shows an accounting loss due to non-cash expenses like depreciation, positive free cash flow indicates it’s generating real, usable cash.
Next, check operating cash flow. This reveals if the underlying business model is working, even if accounting profits are negative. Furthermore, if cash flow’s consistently higher than earnings, it may point to non-cash write-offs rather than operational weakness.
Stability
For a company to be stable, it must have manageable debt levels and a reliable business model. Penny stocks typically can’t borrow heavily, so low debt levels are generally a good sign. A manageable debt load gives a company more flexibility and lowers the risk of insolvency.
Look for debt-to-equity (D/E) ratios under 1 — this is the safe zone (but zero or minimal debt’s even better).
Unlike most blue-chip stocks, there’s less assurance that a small business is reliably managed and well-positioned. Ask – is it innovative, and is there a large enough market for its products or services? It also pays to check whether insiders (employees, management) are buying shares in the company.
If they’re selling, that’s a big red flag!
One example
Consider the cutting-edge research organisation hVIVO (LSE: HVO), a London-based company that conducts vaccine and treatment trials. Its state‑of‑the‑art quarantine facility in Canary Wharf is the largest of its kind in the world.
The company’s operating margin is an impressive 15% and it has a 20% return on capital employed (ROCE). Both are strong signs of profitability. Debt looks manageable, with a low D/E ratio of 0.29.
Its FCF’s £9.72m but, more importantly, its price-to-cash flow (P/CF) ratio’s a decent 6.58. This equates the share price with cash flow, and ideally should be below 10.
Plus, its price-to-earnings (P/E) ratio’s only 7.5, so it has decent growth potential.
Yet despite all this, the shares are down 60% in the past year. This is partly due to a 34% drop in earnings growth year on year, even though revenue grew 12% in 2024. Subsequently, the company’s net margin has almost halved since 2023.
But most of the losses occurred only last month when a key contract was cancelled, prompting a profit warning. If further cancellations occur, it could result in a single-digit loss for the full year.
This highlights the volatility risks associated with small-cap shares.
Overall, I still think hVIVO’s an impressive company with lots of potential and is worth considering. It has strong fundamentals, offers a highly innovative service and operates in a niche market.
But like all penny stocks, it’s high risk/high reward.
