Occasionally as you’re flipping through the droves of companies on your screener, getting a migraine from seeing negative shareholder equity and negative 10,000% net margins, you find an easter egg. A profitable company in the wild! You flip over to Twitter and type in the ticker…nothing! Just a bunch of tweets from three months ago from bot accounts spamming quotes from their latest press release.
So naturally, as a savvy investor, you open their latest 10Q and annual report and start some light reading. What do we find out…boring! This company makes toilet seats, grows revenue at a slow pace, but turns a consistent profit. If it isn’t going to explode to the moon like $ABML, why in the world would I invest in this? Herein lies the purpose of this article…
What are our Target Companies?
First, to set the stage, the companies I’m talking about today are generally small businesses with anywhere from $1 million -$20 million in revenue, have less than 100 employees, and generally grow at slow pace not much more than the US GDP. They, for whatever reason, decided to go public to get investor funding to expand. Maybe the owner sold off 49% of the company in an IPO to several investors and it now trades on the OTC or OTCQB. These are the kinds of places you see driving around your local industrial park, they aren’t sexy but they turn a profit consistently and deliver for their shareholders.
So how do we find value in these stocks? We need to identify these companies when they are trading at a discount to their intrinsic value as with any large cap stock. In other words, the market is undervaluing their actual worth. However, we need to remember some key factors when it comes to the micro-caps, and I’ll get into those below.
Now, here are my two favorite ways to value micro-caps of this type. Below are financials from a stock I follow, RJD Green Inc., or $RJDG. If you want to follow along, you can open up their 10Q from the period ended May 31, 2021 on OTCMarkets.com.
Price to Earnings (“P/E”) Multiple using Comparables
Price to earnings is defined as the market price of a stock divided by the latest twelve months earnings per share (“EPS”). Using the example above, EPS is our annualized net income divided by the outstanding share count, or 0.001 (rounded). Shares for $RJDG are trading at 0.0095 per share in this example. So, if we follow the above formula, P/E = 0.0095 / 0.001 = 9.2281. In other words, the price of one share is 9.2281 times its earnings per share.
If you think about P/E the other way around, if we take 1/9.2281, that is 10.84%. We call that our earnings yield. Basically, one share is yielding you 10.84% in earnings. Put differently, if the company paid out 100% of its earnings in dividends, your dividend yield on the cost to buy one share would be 10.84%.
Now, what does this P/E ratio of 9.2281 tell us about if its undervalued or overvalued. This is where we start inferring and opinion time starts.
Identify Comparable P/E Ratios
One way to try to estimate this is by looking at companies in the same sector and look at what P/E they trade at. So we get a big list of companies and their P/E’s from one of your favorite stock screeners in as similar an industry as we can get it.
Next, we can’t just pick any random P/E ratio or company, every company is different. Also, as you’ll notice, you’ll mostly only be able to find mid to large cap stocks. We now need to do two things. First, to be more conservative, figure out the median of the dataset of P/E ratios. This will hopefully normalize the set and give you a central data point.
Adjust for the Market Capitalization Premium
Next, and we’ll get into this into more articles, you need to account for the fact that the smaller the company, the riskier it is. It’s sometimes called a market capitalization premium. In short, companies that are smaller in terms of market cap trade at a discount to their larger peers due to a greater perceived risk. This tends to drive share prices down.
This is opinion time, but to account for this take your median P/E ratio and divide by 2 as a rough estimate.
Calculate the Intrinsic Value and Determine if its Undervalued or Overvalued
So, you now have a target P/E ratio where you think the company should be trading at, you have the actual P/E ratio based on the real market price, now we just compare! Calculate the percent difference between the two P/E ratios. If the P/E of the comparables is higher than the P/E using the actual market price, the stock is undervalued, and vice versa.
In my example above, my model inputs tell me that the stock is undervalued by 28.95%. This means that you think the stock is currently trading below where it should be, and eventually the market will revert to your calculated intrinsic value with a P/E of its comparables. To revert to the intrinsic value, investors will buy up shares until the price reaches the intrinsic value.
Another method is to take the current trailing twelve months EPS and multiply by both P/E ratios. This will show you the market price per share again, as well as the intrinsic value per share. Simply compare the two, if the intrinsic price is above the market price, the stock is undervalued in your opinion.
Warning – these models are highly sensitive to your inputs. My inputs resulted in it being undervalued, but even small changes in the P/E assumption will make it overvalued. Tread carefully!
Price to Book Ratio using Comparables
This method follows the exact same process as above, but with a different ratio. This is the Price to Book ratio, or “P/B”. P/B is defined as:
(Market Capitalization / # of Shares Outstanding) / (Value of Equity on Balance Sheet / # of Shares Outstanding)
P/B is generally above one and usually means that the market price per unit of equity is at a premium to the book value. As market price goes up, all else equal, P/B goes up. And vice versa.
I won’t re-hash this in too much detail because I did it above, so take the same set of companies from the P/E examples, get their P/B ratios, find the median, and divide by 2. That is your comparable observation. Now, compare the comparable P/B to the actual P/B you calculated from the company balance sheet just like in the P/E example. If your comparable P/B is greater than the actual P/B, the stock is considered undervalued based on your model.
As you will see, my example happened to show only a slight undervalue. It is up to the investor to decide which metric is more meaningful. I’ll have more articles on this later.
By using these two hard and fast litmus tests, you can decide if you really want to dive into a company in much more detail. I cannot stress this enough, THESE TWO METHODS ARE NOT THE BE-ALL END-ALL IN YOUR DUE DILLIGENCE PROCESS! Think of these as an first initial screen. You will find that if you apply this for these types of companies, you will immediately dismiss many companies simply because the market is overvaluing them right now. If that’s the case, set a stock alert for your calculated intrinsic value and move on. It may never hit that level, but over time you’ll find some stocks end up back in your wheelhouse.
DISCLAIMER – THIS IS NOT FINANCIAL ADVICE AND IT IS INTENDED ONLY FOR EDUCATIONAL PURPOSES. THIS ARTICLE SHOULD NOT BE CONSTRUED AS A RECOMMENDATION OF ANY STOCK, INCLUDING $RJDG, OR A RECOMMENDATION OF ANY SECURITY OR FINANCIAL INSTRUMENT. AS OF THE TIME OF WRITING THIS ARTICLE, I OWN A LONG POSITION IS $RJDG. ANY ASSUMPTIONS OUTLINED ABOVE ABOUT $RJDG ARE ARBITRARY AND SHOULD NOT BE CONSTRUED AS FACT.