4 Financial Ratios to Look Out For When Investing In Small & Mid-Cap Stocks
Investing in stocks can be lucrative, but so does it come with its fair share of risks. While most investors tend to focus on stocks of large and popular companies, there is usually some value worth pursuing in small and mid-cap companies.
The amount of volatility associated with small-cap stocks is much lower than what is usually on offer with large-cap stocks. However, it does not mean that it is impossible to generate significant value on small and mid-cap stocks on taking advantage of price fluctuations.
A small-cap stock is simply a stock of a company with a market capitalization of between $300 million and $2 billion. Conversely, a stock is considered mid-cap if it has a market capitalization of between $2 billion and $10 billion.
When it comes to investing in small and mid-cap stocks, there’ are a number of financial ratios that professional investors often pay close watch to. Investors analyze these ratios with a view of ascertaining the true value of a stock before putting any amount of money to use.
Revenue and Net Profit
As a rule thumb of investment, it is important to invest in the small and mid-cap stock of companies showing consistency when it comes to revenue and net profit growth. Companies with tremendous growth potential and the ability to generate long-term shareholder value are synonymous with steady or exponential growth in revenue.
Small and mid-cap companies are usually in the initial stages of growth, thus expected to be growing at an impressive rate. A would-be investor can only ascertain this by looking at the income statements to see the amount of revenues as well as net profit generated in previous periods
A company whose revenue is not growing would essentially imply it is in a sector where growth would be hard to come by in the future. Likewise, any serious investor should shun such stocks regardless of how cheap they are trading at.
Net profit is another important metric worth paying close to watch, too, as it underscores the ability of a company to generate long-term shareholder value. A company whose net profit is on a downward trajectory could imply an increase in operational costs. A company whose operational costs are increasing at a much faster rate than revenues should arouse concerns about growth going forward.
Gross and Net Margin
Gross and net margin are other important financial ratios worth paying close watch. The metrics underscore management ability to optimize each available dollar of revenue earned. Likewise, a high gross margin indicates a company’s ability to continue growing while relying on underlying revenues rather than external financings.
Similarly, it is important to compare a company’s gross and net margin with that of the overall industry. The comparison will, in this case, provide valuable information as to how the company is performing relative to peers subjected to the same factors in the industry.
A company with a much lower gross and net margin relative to the overall industry could signify inefficiencies in the utilization of the available resources to generate the much-needed profits. Similarly, a much high gross and net margin could signify an effective management style in the maximization of available resources to generate profits.
Ownership as a financial ratio underscores the amount of stakes that founders and directors own in a given a company. The fact that small and middle cap companies are usually in the early stages of growth sees founders retain a majority of shares. Even on the company going public, it is usually expected that the founders would retain a majority of interest in the company.
Founders retaining a majority of the shares many at times affirm their commitment as well as confidence in the company’s ability to generate long-term value. A management team where founders have no stake in terms of ownership should arouse concerns. For starters, it would indicate they do not believe in the company’s ability to generate long-term value thus the reason why they are not investing in the company
Similarly, a situation whereby insiders in the company are increasingly buying a company’s shares in the market is usually interpreted as a buying opportunity in the market. Insiders would often buy a company’s shares on taking advantage of information about a company that is only known to them and not the public.
It is crucial to invest in small and mid-size companies with strong balance sheets. Therefore, a company’s financial position is an important financial ratio to consider when it comes to investing in such stocks. A company with a strong balance sheet is often well-positioned to navigate various economic cycles and survive lean years.
In this case, the total debt should be less than the tangible book value, which is essentially the value of total assets minus goodwill, liabilities, and intangible assets. Likewise, lower debt levels leave a company well-positioned to use available resources on strategic initiatives able to accelerate growth.
A small and mid-cap stock worth investing in should also have a total debt that is less than two times its net current asset value. Companies meeting these criteria are often able to meet their short-term debt obligations and tend to be more stable.
Current ratio is another important metric to consider when it comes to analyzing a company’s financial position. In this case, current ratio is current assets divided by current liabilities. For a solid stock worth investing in, the ratio should be greater than two should as it signifies a company’s ability to meet its short-term obligations
Ideal small and mid-cap stock worth investing in are those registering steady revenue and net profit growth in addition to boasting of higher net and gross margin relative to the overall industry. Similarly, it is important to consider insider ownership in the form of directors and founders. Such a company should also boast of a solid financial position ideal for navigating various economic cycles with ease. Likewise, such companies should trade at a fair price relative to their underlying fundamentals.