Looking for a great value? Your first thought might be to look for a blue-chip stock that’s going through a rough time. You might actually have better luck combing through overlooked small caps. That’s right: there are such things as small cap value stocks. There are plenty of small, relatively undiscovered companies on the market that have yet to hit their growth phase. When they do, they reward shareholders who were confident enough to grab them at a value price. 

Here’s a closer look at what it means to prospect small cap value stocks, and how to identify them vs. struggling small caps. 

Small cap value stocks can enhance your portfolio

What is a Value Stock?

A value stock is one that’s undervalued by the market relative to any number of financial metrics. For example, if the company’s share price vs. its total outstanding shares is lower than its book value, the company is fundamentally undervalued—meaning it’s actually trading for less than the sum of its whole. In other cases, a value stock might trade lower relative to the value of its peers—at four-times forward earnings as opposed to an industry average of seven-times forward earnings, for example. 

Typically, the concept of a “value stock” arises when looking at larger, more established companies. Investors prefer to prospect undervalued large- or mega-cap companies because they have a higher chance of price correction due to exposure. However, small cap companies can also be value stocks—especially if their fundamental financial values are higher than the market gives them credit for. 

How Can Small Caps Be Value Stocks?

Investors undervalue small cap companies for many reasons. Some are unproven in the public market, so even with good financials investors are wary. Other times, investors overvalue sector headwinds and assume small companies will suffer against them, without actually evaluating the company’s position. Regardless of the reason they’re undervalued, these small cap stocks are nevertheless value stocks. 

Top-Performing Small Cap Value Stocks

Some of the biggest companies in the world today were once small cap value stocks. They were companies struggling to push into markets, yet later, disrupted them to the point of dominance. Here are a few of the all-time best performing small cap value stocks turned multi-bagger billionaire-makers:

  • Amazon (NASDAQ: AMZN) fell to a low of $7 per share in 1998, after IPO at $18.
  • Tesla (NASDAQ: TSLA) barely cracked a billion dollars in market cap in 2010.
  • Gamestop (NYSE: GME) was $4 in 2020, before jumping to over $200 in 2021.

While we think about these companies as large- and mega-caps today, they were, at one point, small cap value stocks. Investors saw many reasons to buy in: disruptive technology, strong market demand and even simple miscalculation on the part of bearish sentiment. 

The above are extreme examples. There are many, many other examples of small caps that get overlooked because of their size, rather than on the fundamental basis of their financials. As a result, they fly under the radar until investors take the time and care to properly valuate them. 

How to Identify Small Cap Value Stocks

So how, exactly, can investors comb through the thousands of small cap stocks to identify value plays? The key is to identify important valuation metrics that signal a surface undervaluation. Then, use those metrics as a starting point to probe the company’s financials deeper. Some of the best valuation metrics to use for small caps include:

  • Price-to-book (P/B) ratio. A P/B figure that’s lower than the market price means the company is fundamentally undervalued by investors. 
  • Price-to-earnings (P/E) ratio. The lower the P/E, the more affordable the company’s stock price as it relates to its revenues. 
  • Price-to-sales (P/S) ratio. If a small cap isn’t profitable yet, P/S is a good substitute for P/E, as it measures the company’s money making activities. 
  • Debt-to-equity (D/E). A good D/E ratio suggests that a company has few financial obligations and a higher revenue potential than the market gives it credit for. 

There are many other valuation metrics that help to contextualize the value of a stock vs. its market price. Ideally, investors want to look for small caps that have a better balance sheet and a stronger operational model than the stock price indicates. Don’t forget about qualitative variables, such as the competence of leadership or the company’s value proposition. 

Get in at the Ground Floor, at a Great Value

Small cap stocks offer an enticing value prospect. Not only do they come with the boom-or-bust potential of every other small cap company, the fact that they’re undervalued adds additional ROI. It’s one thing for a $20 stock to go to $100 in a couple of months; it’s another if you bought in at $10, before it was on the radar. 

When prospecting small cap value stocks, be diligent in vetting them. It’s very easy to see the potential of a small cap and ignore financial or operational red flags. As is the case with any value stock, looking too much at the potential ROI and not enough at why it’s undervalued could leave you holding the bag. Use fundamental evaluation tools to review the company’s finances and hedge your positions—especially for small caps. 

Prospecting small cap value stocks is a risky investment strategy. These underrated gems have as much potential to tank as they do skyrocket. A well-researched investment vs. a hunch play is what will make sure you benefit from a small cap value stock and not one that’s destined for the pink sheets. 

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