5 reasons this could be the perfect small-cap stock

Updated: 
FTSE 100 rising prices

While small-cap stocks can be more volatile than their larger peers, there's no doubt that many have the potential to make their shareholders life-changing amounts of money. With that in mind, today I'm taking a closer look at £590m market cap Gamma Communications(LSE: GAMA), an under-the-radar small-cap stock that appears to have considerable potential.

Business Description

Founded in 2001, it is a provider of cloud communications services. The company provides voice, data and mobile services for the business market, and clients include Pret, Itsu and Cathay Pacific. Gamma listed on the AIM market in late 2014 at a price of 187p, and the shares have risen almost 250% in just under three years. However, I think there could be more to come.

Revenue & earnings

The first thing that appeals to me is the company's financials. Revenue has increased from £131.4m in FY2011 to £213.5m last year, a compound annual growth rate (CAGR) of 10.2%, and adjusted earnings per share since the company listed have risen from 15p in FY2014 to 21.1p last year.

Gamma released its FY2017 half-year report this morning, and unveiled another solid set of results. Revenue for the half year climbed 9.8% to £115m, profit before tax increased 17.9% to £12.5m, and adjusted earnings per share rose 14.9% to 11.6p.

Cash flow

Gamma also appears to be generating plenty of cash flow. The company generated operating cash flow of £26.5m for FY2016, and had a cash balance of £28.2m at year end. Today's half-year results reported adjusted net operating cash flow of £15.3m, up 10.9% on last year.

Dividend

The strong levels of cash flow have enabled the company to pay a dividend to its shareholders every year since listing. Small-cap stocks aren't usually associated with dividend payments, however, if a smaller company does pay a dividend, I see this as a huge plus.

A dividend indicates to me that not only is the company generating real cash flow, but also that management is confident that the company is in sufficiently good health to return cash to shareholders. It's also a sign that management values the shareholders, and is willing to reward them with a share of the profits.

While Gamma's dividend yield is not high at 1.1%, the payout has risen from 3.95p per share in FY2014 to 7.5p per share last year, and City analysts expect further growth of 10% for this year. The interim dividend was increased by a healthy 12% today, from 2.5p to 2.8p.

Valuation

Analysts forecast FY2017 earnings of 23.7p, which, at the current share price of 669p, places the stock on a forward P/E ratio of 28.3.

While no bargain, that level of P/E suggests to me that investors are willing to pay a premium price for a high-quality company, and I see that as a good thing.

Companies that trade cheaply are often cheap for a reason (think of Telit Communications) and companies that trade at eye-wateringly high valuations (like IQE) leave little margin for error. However, a P/E of 20-30 indicates to me that the market is aware that the company offers growth potential, without a level of irrational exuberance attached to the stock.

Lastly, a glance at the chart shows that the stock is clearly in an uptrend. And as they often say in investment circles, "the trend is your friend."

Another small-cap stock that has bags of potential 

If you're looking for another under-the-radar small-cap company with significant potential, check out the stock listed in the report A Top Small Cap Stock. 

The report has been put together by Mark Rogers, Head of UK Investing at The Motley Fool and can be downloaded for FREE,  simply by clicking here

Edward Sheldon has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.