A shortcut to valuing penny shares

Penny shares can deliver big profits to patient investors. But how do you value such early-stage companies, when many may not even be making money when you first invest? Tom Bulford gives his favourite method.

It can take a lot of guts to be a penny share investor. You have to be patient. You have to be prepared to take risks. And from time to time you may even have asked yourself: why do I put myself through it?

Well there is a good answer to that question – it’s worth it.

I firmly believe that penny shares are the best way to make serious gains in the stock market.

But today I want to tackle that business of being patient. Because the truth is that when we invest in penny shares, we often have to wait as much as a year or two for the investment to pay off. Some companies might not even be making any money when we invest. How do we deal with that uncertainty?

Well one way is to make use of the ‘discount rate’. Today I’d like to show you how to use this simple valuation tool. And how it can help you keep sight of the huge potential returns when you invest in penny shares.

Would you pay me £3m to install this machine?

Picture a machine that stands in the corner of your living room tossing out £5 notes. It’s a nice idea, isn’t it? I think you would be willing to pay for that even if I told you that the £5 notes would not start flowing until 2017. The question is, how much would you pay?

OK, so here is the deal. I promise you that this machine will throw out £5 notes at the rate of one hundred a day, starting in five years’ time. This wonder machine will disgorge a fresh new £5 note every fifteen minutes or so, delivering £182,500 into your eager hands every year.

So how much will you pay me, today, to install this machine in your front room?

First of all you need to decide how much £182,500 per annum is worth to you. Given that the rate of interest offered by a bank is barely 3% you should be pretty happy to receive a 6% return on your money. That means you could afford to pay just over £3m. You pay me £3m. I give you a machine that delivers £182,500 per year – a return on your money of a fraction over 6%. How about it?

A few questions should immediately come into your mind. First, what is the cost of having this machine in your living room? Does it have to be plugged in to the electricity? Does it take up room that could be put to some other profitable use? Does it require maintenance? In other words is that payment of £3m going to cover everything? You may want to knock the price down to £2.75m, to cover such eventualities.

 

Next you need to ask yourself whether you trust me. Am I a huckster? You might have your suspicions. Can I really be offering a machine that produces pure cash out of thin air? It does sound a little too good to be true! So perhaps you should negotiate me down to £2.5m.

Then you should ask whether the world will be the same in five years’ time when the machine rumbles into action. Will we have experienced inflation? How much will £5 be worth then? Will somebody have come up with a better machine that can knock out fivers every ten minutes instead of every fifteen? To allow for these doubts, you may value my machine at no more than £2.25m

But now here comes the really key question. You may conclude that you would be willing to pay £2.25m for this machine in five years’ time. But I am asking you for payment today! If the machine is worth £2.25m in five years, how much is it worth today?

A shortcut to valuing your favourite shares

To work this out we need to use a crucial tool called the discount rate. We must discount £2.25m back over five years to come to a ‘present value’. This is an absolutely key concept in finance in general and penny shares in particular, and it is very amenable to sharp practice.

The basic question is this: it is obviously better to have £2.25m now than to have it five years hence. But how much better? Well here we make use of a simple formula:

Future Value = Present Value x (1 + i)n

Where i is the discount rate and n is the number of years.

So we find that: £2.25m / (1 + 0.08)5 = £1.53m. If we discount the future value at a rate of 8%, the future value of £2.25m is worth £1.53m today. But if we are more cautious and use 12%, that distant £2.25m is worth only £1.28m today – a big difference, and one that widens further with each year that is discounted.

Here is a practical example. Last week I spoke to the boss of a South American mining company that hopes to be producing nickel in five years’ time. Based on the projected returns of this mine he argued that his share price was undervalued. But this assumed an 8% discount rate, which seems low given all the uncertainties of mining.

Next I spoke to the boss of a company that has a very clever product for extracting value from waste. His shares look undervalued, even after using a much harsher discount rate of 12% and this despite the fact that the project looks rather less risky than the South American mine. He has been conservative; the South American miner has not.

Analysts and stock pushers are very adept at juggling discount rates on future earnings in order to justify high valuations today. But they can’t fool me! That conservative waste-to-value producer is in the Red Hot Penny Shares portfolio, and its shares are up 150% this year.

Try it out

So go ahead and try it. Discount the projected future value of your favourite stocks back by the rate of return you demand each year. It’s a very useful exercise for any investor.

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