Many investors fail to understand valuation when they buy a growth stock.

We see it all the time: Individual investors who buy a small cap stock based on its trading momentum and ignore the market valuation of the stock they buy. This leads to heavy losses after the stock price peaks and then rapidly declines. At this point, the price of the stock could take a long time to recover (if ever) and the decision to sell becomes emotional when your small cap investment has declined in value much below your cost base.

This is a common mistake by small cap investors that we call: Buying a stock that is priced for perfection.

First off, an investor must accept that small cap stocks are almost never perfect investments. There can be many unexpected reasons (both market- and company-specific) that can have a dramatic impact on a small cap stock price. To this point, small cap stocks can be very volatile and rarely behave like reliable investments while you hold them.

Therefore, why would investors buy small cap stocks that are already priced for perfection? These "perfect" stocks trade at market valuation that assumes the underlying company’s longer-term business plan has already been executed. This means that the stock will need to meet and exceed all expectations going forward all the time. Is this realistic? Not really.

Often novice investors purchase that small cap/microcap stock priced for perfection based on its sexy industry, share price momentum or the fact that they heard about the stock touted on a business television show. But before they do, they should do one simple math calculation by figuring out the market capitalization (the company’s current worth) of the stock they are buying.

Simply market capitalization equals the amount of stock outstanding (or issued) by the company multiplied by the stock’s current trading price. For example, if the current stock price is one dollar and there are 100 million shares issued by that company, then the market capitalization is equal to $100 million dollars. (Note: For the purpose of this example, we will assume no outstanding warrants or convertible debt which could alter the future valuation.)

Following the calculation of the market capitalization is when the reality check needs to happen. Too often we see high-flying small cap stocks that currently have little in annual sales (not to mention earnings) but trade at an excessive market capitalization. If our $100 million company today has only $5 million in annual sales, its current market valuation is 20 times that amount. A prudent investor must consider all the variables in order for that company to achieve that amount of future annual sales closer to its current worth, which is a big gamble to say the least.

When calculating sales to market capitalization multiples for small cap stocks, we would encourage small cap investors to pay less than 2.5 times for that stock price, especially for companies without earnings. We also note that buying wisely is also buying a small cap stock from companies that have a good balance sheet; preferably with ample cash on hand and little or no debt.

So, next time you are inclined to buy that intriguing small cap stock, do the simple math first. It might save you a bundle in losses or it may prove to be the perfect time to buy!

Read Disclaimer:

This article is for informational purposes only. This article is based on the author's independent analysis and judgment and does not guarantee the information's accuracy or completeness. The information contained in this article is subject to change without notice, and the author assumes no responsibility to update the information contained in this article. The information contained within this article should not be construed as offering of investment advice. Those seeking direct investment advice, should consult a qualified, registered, investment professional. This is not a direct or implied solicitation to buy or sell securities. Readers are advised to conduct their own due diligence prior to considering buying or selling any stock.