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Why you need to pay attention to the PE ratio of a penny stock

by , 12 September 2014

Investing in penny stocks can prove to be a profitable endeavour. You can make money by investing in the right small company.

When you invest in a penny stock that's soaring, it can be hard to know when to bail out. You don't want to see your profits disappearing as the share price heads south.

That's what it's important to keep an eye on its PE (price earnings) ratio.

Let's take a closer look…


The PE ratio of penny stocks


When it comes to penny stocks, a very high PE ratio isn’t a rarity. It’s often the case with shares that are growing rapidly.

But as a company grows, it’s harder for a business to maintain a high growth rate.

At some point the market realises the rate of growth is going to start to ebb. A de-rating ensues.

Sometimes the de-rating is rapid, David Thornton in Penny Sleuth explains. In other cases, the share see a slower de-rating. For instance, the share doesn’t perform as well as you’d expect as the company’s prospects look so good.

This can be hard to spot initially. But it’s a case of the market adjusting its long-term growth rate downwards.

This doesn’t mean that the forecasts for earnings have changed. But the company’s PE will fall to reflect a more cautious view of the long-term.


Factors that can influence a PE ratio


There are two main factors that influence PE ratios:

  • The long-term growth rate of a share; and
  • The level of confidence the market has in that growth.

That’s why investing in penny stocks, which are inherently growth shares, is tricky but potentially rewarding.

If one of your penny stock’s PE ratio is high, ask yourself if this means the market expects it to grow exponentially. If you think that’s the case, then reduce your risk and take some profit.

So there you have it, why you need to pay attention to the PE ratios of penny stocks.

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Why you need to pay attention to the PE ratio of a penny stock
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