For every large company with high market capitalization, there are many smaller companies or businesses which have much lower market caps. These companies are small which means that their business is relatively high risk and they therefore trade at prices which are a mere fraction of the prices at which large cap stocks trade. These are the stocks that are referred to as penny stocks because you can often buy them for a few cents apiece. However, beware of the sharks that lurk in the penny stock ocean.
There is often a simple but naive belief that all penny stock companies will eventually become large companies and trade like them. Some of the penny stock companies may indeed this but they are far fewer than many people would imagine. Many of these companies will simply fall by the wayside and die. Many companies defer the process of going public till they are large enough to profit from the exercise. Until this happens, their funding comes from their profit from their operations as well as loans from banks and financial institutions as well as equity from private investors. Only when companies reach a certain size is an IPO worth the time and expense involved. Moreover equity is expensive when compared to debt and companies would prefer to avoid raising equity till the size of their operations grows to a point where a substantial equity base is absolutely essential.
If the company offers its stock as a penny stock, there are several reasons for doing so. The company may require funds for growth or expansion and other than an IPO, no other source of funding is available. Alternatively, the company may have reached the limits of its business growth and is seeking an exit route for its existing investors. These are legitimate reasons but, often, the penny stocks are offered with less than noble intentions in mind. Sometimes the company can be misled by penny stock brokers who are looking to make a quick buck. They are induced to issue overpriced stock which is then sold to unwary investors by generating a lot of hype. It could also represent an effort by the existing owners of the company to offload their stakes because the company is not performing to expectations.
It is important to remember that penny stocks come in all sizes and shapes and can range from a company in a respectable business with a proper corporate structure to a mom and pop shop growing cabbages in their backyard. Seasoned value investors rarely touch penny stocks because lax regulation does not allow them to acquire the kind of information required for a detailed analysis. Inexperienced investors are lured into investment in penny stocks in the expectation that they can buy shares for $.25 apiece and sell them for $2.50. Unfortunately the sharks in the penny stock ocean know exactly what these investors are thinking and set the bait accordingly. And they will pump the stocks with the use of height and misleading information by using online channels such as newsletters and investing forums. They will feed the would-be investor with exactly the kind of greedy expectation that would induce him to jump into the penny stock ocean.