Why I’d avoid UK Oil & Gas Investments plc and consider this growth stock instead

Roland Head explains why he believes UK Oil & Gas Investments plc (LON:UKOG) is too expensive.

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Today I’m looking at two very different small-cap stocks. One is a company that’s delivered a 250% gain in just one year, despite having no revenue or profit.

The second company is a business whose shares haven’t moved much over the last year, but which has just reported an 11% increase in half-year sales.

Which of these stocks makes most sense for growth investors?

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Improving outlook

The second company I mentioned above is Castleton Technology (LSE: CTP). This is a Cambridge-based technology group which provides software for the social housing sector. Formerly known as Redstone, Castleton has a market cap of about £45m.

The company published its half-year results this morning. Sales for the six months to 30 September rose by 10.9% to £10.8m, while the group’s operating profit for the period rose by 50% to £353,000.

This improved performance was also reflected in the group’s cash generation. My calculations suggest that free cash flow, after costs relating to earlier acquisitions, was £1.1m. This cash helped to reduce the firm’s net debt to £8.0m, down from £9.7m at the end of March.

My view

Today’s figures suggest to me that Castleton is on track to hit broker forecasts for sales of £22.7m this year, with adjusted earnings of 4.86p per share. At 62p, this gives the stock a forecast P/E of 12.8.

An alternative approach is to value the stock on free cash flow. I estimate that Castleton has generated about £2.8m over the last 12 months. That gives the shares a trailing P/FCF ratio of around 16.5.

This valuation seems about right to me. So while this business seems to have potential, I’d need to do further research before making an investment decision.

Time to take profits?

UK Oil & Gas Investments (LSE: UKOG) recently confirmed that it’s been given planning permission for a further round of flow testing on the Horse Hill-1 (HH-1) well.

If the results are positive, then this could be good news for shareholders. But I think it’s important to focus on the financial picture, as well as the operational situation.

The group had a cash balance of just £1.1m at the end of March. But during the six months to 31 March, UKOG reported cash outflows of more than £1.4m.

Given the firm’s activities over the last seven months, I think it’s fair to assume that this cash balance will now be quite low. I think there’s a strong chance UKOG will have to raise some fresh cash through another dilutive share placing, probably at a discount to the current price of 5p.

Major investor selling

Back in January, French oil firm SCDM Energy Ltd acquired a 3% stake in UKOG. In July, this rose to 5%.

However, SCDM sold heavily in October. Its last reported stake was just 2.55%, below the level at which disclosure is required. So the remaining shares may now also have been sold.

UKOG shares were trading at about 1.5p in January. As they were above 5p in October, SCDM has probably made a healthy profit. But why would this expert investor decide to start selling directly before the Horse Hill flow tests are due to start?

In my view, the most likely explanation is that SCDM believes UKOG’s market cap of £177m is already high enough, given the unproven quality of its assets.

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Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head 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.

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