Key Metrics for Spotting Small-Cap Stocks

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There are only three letters that investors need to know to be able to find stocks that have the potential for big gains: P, E, and G. Combine these and you get PEG, an acronym for the most simple and powerful stock analysis metric for identifying growth stocks today.

In The Small Cap Investor, I devoted a chapter in my book, Financial Projections and Valuations to the PEG ratio. The simplicity of this ratio is what makes it so useful for identifying small cap growth stocks.

PEG calculates the P/E ratio of a stock in comparison to the growth rate of the company. The calculation allows you to determine the valuation of the company relative to its growth rate. PEG is an important measure because it allows us to understand the value that is being placed on the company's financial growth. I look for low PEG ratios -- the lower, the better. A PEG ratio equal to 1.0 is often considered a fair value. What this means is that companies whose stocks have a PEG below 1.0 may be undervalued, and those above 1.0 overvalued.

Earnings estimates typically cover a period between three months to one year. In my opinion, estimates that extend past a year should be practically ignored. It is difficult to have realistic longer-term estimates for a business's performance, and this is particularly the case for small-cap stocks where their products, partnerships, and marketing can change dramatically in a short period of time. That being said, strong financial performance over the long-term can point to high-quality companies with good leadership at the helm.

I typically look for small-cap companies that are reporting revenue and earnings growth of at least 20 percent per year. These are the companies that I have found to have the greatest profit potential for their shareholders. They often have a higher probability of long-term success, and this often equates to significant capital gains.

Take for instance Real Goods Solar, Inc. (RSOL), one of the premier makers of solar panels for homes and businesses. It sold the first retail solar panel over 30 years ago and has not looked back since. Analysts estimate that Real Solar revenues for the coming year will increase 27 percent. With a healthy expectation for revenue growth, it's worth looking into the valuation of the company.

When beginning a search for high-quality but reasonably-priced small-cap stocks, I start by looking at the most popular tried-and-true metric: The price-to-earnings (P/E) ratio. The ratio is calculated by taking the share price of the stock divided by the earnings-per-share (EPS).

Taking a look at Real Goods Solar, I see that the stock has forward P/E ratio of 18.4, based on it's share price of $2.45 and 2011 EPS estimates of $0.13. This PE is slightly below the peer group, with an average forward P/E of 20.3. The stock has a PEG ratio of 0.32 based on the blended growth rate for 2011. The blended growth rate is just the average of the revenue and EPS growth rates from 2010-2011. Real Goods Solar falls below 1.0, which means it's most likely undervalued.

So based on the initial growth screen, Real Solar passes the first test. For the small-cap investor, this is a great starting point to learn more about this company by asking questions about the company's long-term growth, prospects for expansion, and the value of its shares. Let's look at the growth rates to see if the company could be in the early stages of rapid growth.

I will be back next week to discuss my next steps in completing a more thorough research and analysis of Real Goods Solar.

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