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If someone buys a share for a penny and it reaches a pound, their return will be 10,000%. Buying the same share at 50p and seeing it hit a pound means a return of a far more modest 100%.
That logic has an attractive element to it. But it is also highly simplistic.
Some penny shares turn out to be screaming bargains. Others though, fall until they are worthless.
So, does being a price in pennies make a share cheap?
How to value shares
The answer is definitely ‘not necessarily’.
A penny share may be cheap – but it may be wildly overpriced. The same is true for a share selling for £1 – or £1,000.
That may seem surprising. But a share is an object for sale, just like a cup of coffee, a car or a house. When looking at those things, we tend to make a judgement about what we think they are worth and how that compares to the asking price.
In the stock market, the same thing applies. Whether a penny share is cheap or not is not simply about its price. It is about whether that price is above or below what the share is really worth.
That is where things can get complicated. As can be seen from their share price movements, investors cannot typically agree about what a large, well-established business like AstraZeneca or HSBC may be worth. So how can they possibly hope to agree about the value of a penny share?
Often (though not always), such shares have either an unproven business or one that has yet to prove consistently profitable on a large scale in a way that looks sustainable.
Hunting for opportunities
That can open a potential opportunity for investors. Some penny shares could soar if their unproven business model comes good.
Such a level of risk may suit some investors, but it is typically above what I look for.
However, there are some penny shares that do have proven business models and still look like offering potentially good value from a long-term perspective.
For example, Topps Tiles (LSE: TPT) sells one in five tiles bought across the UK. It has a strong brand and has expanded its multichannel offering in recent years, using professional brands to help target potential buyers such as builders and architects. It pays a dividend too.
Despite that, the price is now 11% lower than it was five years ago. That period has seen it reach double its current level, before falling back down.
As with any shares, Topps faces risks. An uncertain property market could lead to some sales being deferred or cancelled. But I see it as a promising sign that the company’s overall adjusted sales showed year-on-year growth of 10% in the most recent quarter. That was helped by acquisitions, but growth is still growth.
Trading for pennies, I think Topps could turn out to be cheap from a long-term perspective. That is why I plan to hang on to my shares.
Crucially, it is not cheap just because it is a penny share. It was selling for pennies even when it was twice the current price several years ago, after all.
Rather, I see it as cheap relative to what I think the business — and therefore shares in it — are worth. So I think it is worth considering.
