Investing in smaller companies

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7. Can you buy at a reasonable price?

Finding good quality growing businesses is the easy bit - there are lots of companies, satisfying all the above requirements on the previous page, that could turn into tomorrow's giants. The problem is getting them at reasonable prices.

Note that all you are looking for is a reasonable price. If you hold out for a bargain price, you might never find a share to invest in.

One of Warren Buffett's oft-quoted tenets is that to be successful you don't need to invest in great businesses at great prices (although that would be nice). You just need to invest in good businesses at fair prices.

So what is a reasonable price? The criterion is the company's price earnings (P/E) ratio, which is calculated by dividing its share price by its earnings per share.

Example

Goodco's current share price is 108p. EPS is 6p. Its P/E is therefore 18. (108/6)

A high P/E relative to the sector and to the market as a whole simply means that you are paying more for the earnings than a company with a low P/E. That sounds bad, but perversely a high P/E also means the market has a lot of confidence in the company's future earnings growth.

• Be wary of very high P/Es (>50) because the risks associated with such companies are commensurately high and if the company disappoints the market in any way, the shares will fall to the earth with a bump.
• Be wary of low P/Es (<10). The market may know something about the company that you don't, or it may just be a boring company going nowhere.

Investors can either treat P/Es, and their offshoot PEGs, as the prime determinant of small cap investment, or they can treat them as support information for a more rounded assessment of a company.

1. What is a small cap? 2. The arguments in favour of smaller companies 3. The arguments against smaller companies 4. The aim of investing in smaller companies 5. No single method 6. Is it a good business? 7. Can you buy at a reasonable price? 8. Penny shares and other speculative stocks 9. A note about tax 10. Other tips 11. Conclusion

• Investor's Guide To Selecting Shares that Perform