When analyzing fundamental valuation ratios for micro cap stocks, it is important not to let any single factor summarily eliminate a stock from consideration. Because of the relatively dynamic financial nature of micro cap companies, there are reasons, at times, to discount some factors while putting more weight on other factors when reviewing the financial ratios of a company. For example, there are many rapidly growing small companies that generate very little free cash flow. Conversely, there are small companies that generate very modest earnings growth but generate significant levels of free cash flow from operations. Simple screening techniques could eliminate either of the companies from consideration; however, a little more effort within the analysis can yield potentially great stocks.
As is the case with financial ratios, certain measures will be more or less applicable, depending on the sector within which a company operates. It is often the best strategy to use ratios that reflect a company’s valuation relative to its peers rather than relative to the market. In addition, it is important to study the accounting practices of the company and its peers to determine whether any adjustments are necessary for different accounting policies and procedures. For example, manufacturing companies tend to lend themselves better to cash flow and EBITDA (earnings before interest, taxes, depreciation, and amortization) analysis, whereas fast-growing service companies tend to better lend themselves to price-to-sales ratio analysis or earnings-per-share growth analysis.