Over the last few weeks, we’ve been sharing some of the Five Secrets of Small-Cap Investing as practiced by history’s best investors. The Third Secret of Small-Cap Investing: Pay Particular Attention to Valuation
Small companies are often attractive to growth stock investors because of their rapid growth rates. But these high growth rates often command a premium in the stock market, so these companies are assigned very high P/E ratios.
That’s fine, as long as the company can continue to churn out above-average growth. Eventually, however, the company’s growth will slow — it must slow — and then the stock’s P/E ratio will come back down to earth.
The math isn’t complicated — a small business can double or triple its sales and earnings in its first few years of operations. But it must see the percentage of annual growth decline as the company grows.
The relationship of a company’s growth to its share price and P/E ratio makes it particularly important to pay attention to the valuation of small-cap stocks in a portfolio. Reviewing past annual high and low P/E ratios may not reveal much about the likely P/E ratios a company’s shares will sell for in the future.
As a result, investors must take special care to make sure that estimated future P/E ratios are in line with expected future growth, which can be quite a bit lower than historical growth rates.
Next: the fourth secret to small-cap investing: Invest Less in More Stocks.
You can learn more in the educational articles included in each issue of the SmallCap Informer, a new monthly small-cap newsletter publication from ICLUBcentral that presents profiles of small-cap stocks with excellent potential for long-term growth. Get a free sample issue now and take advantage of special subscription rates for charter subscribers. Available in online and print editions.