This article originally appeared on The Financially Independent Millennial and was republished with permission.
While having an advanced degree in Econometrics or Mathematics is not a prerequisite to successfully investing in the stock market, value investors who understand some essential industry metrics will better inform your decision-making process.
However, no one single strategy can be defined as the definitive answer to making healthy returns. But an understanding of the available data points can help you validate stocks you may have found along whatever research path you have embarked.
Let’s dive into some of the most common metrics in which value investors should at least have a basic understanding. Then, armed with this knowledge, hopefully, the next basket of stocks you pick will have a more grounded fundamental basis for their selection. And they can go on to be big winners.
What Are Stock Metrics
Stock metrics get used to assess, compare, and track the performance of stocks. These metrics are known as a method of quantitative assessment. And, both value investors and analysts use them to build a picture of how a stock is performing. Using this data, the stocks can be reviewed regularly to monitor their performance and plan future investment strategies.
A wide variety of stock metrics can be used to great effect when choosing an investment strategy. These investment metrics have been developed over time to maximize efficacy and meet industry standards.
Why Should Value Investors Care About Metrics
Stock metrics can be an essential tool for picking which stocks to invest in. Of course, the ratios won’t mean every investment is 100% safe and profitable, but using the investment metrics can help see if a stock is trading at a discount or a premium according to its value based on growth, profitability, and balance sheet.
In most cases, it’s advisable to examine two or three metrics to see how a company compares against its competitors. These metrics also demonstrate if the company is trading above or below its fair value.
For example, using stock metrics can help find undervalued stocks. However, the market reaction means that stock prices don’t always correspond with a company’s future performance.
As an investor, this means you can profit from these opportunities by using various investment metrics to identify valuable opportunities.
The various investment metrics don’t guarantee success but provide you with the knowledge of whether a stock is likely to give you a return.
Expensive stocks could take two or three years to appreciate further. Any stocks trading lower than a company’s fair value are probably lower for a reason–you must know why the stock gets discounted and what is needed for the price to appreciate before you can judge whether the investment is worth it.
7 Investment Metrics to Inform Stock Selection
Stocks can be analyzed using a variety of measures. The seven metrics listed here are some of the most popular stock metrics you can use to find outstanding investment opportunities.
Value investing metric #1: Price-earnings ratio
One of the essential investment metrics is the price-earnings ratio. To calculate this metric, value investors take a company’s current market capitalization and divide that by its annual earnings.
Calculating the price-earnings ratio benefits you in a couple of ways.
First, you now understand how expensive or cheap the stock is. Second, you now know what premium an investor is willing to pay for a company’s earnings.
Looking at the price-earnings ratio can be an excellent way to compare two companies in the same industry, expecting similar levels of growth in the future.
For example, when doing your research comparing Coca-Cola and Pepsi, using the price-earnings ratio would be beneficial. However, comparing Verizon and Wal-Mart won’t be as helpful because they’re in different industries.
Value investing metric #2: Price-to-sales
The price-to-sales ratio is calculated by dividing a company’s market capitalization by its annual revenue.
One benefit of using this ratio is that it helps you compare companies that can’t be judged based on earnings alone. For example, some high-growth companies may have negative earnings. The price-to-sales ratio lets you see if, despite those negative earnings, they’re still worth investing.
Market capitalization gets based on the company’s current market value, which gets worked out by multiplying the current share price and the shares outstanding. For example, ABC Company has 1 million shares outstanding at $10 per share. This means the market capitalization is $10 million.
Additionally, some value investors also choose to include debt when calculating the price-to-sales ratio. Including debt when working out a company’s market capitalization can provide a more accurate picture. This is because one company may have high sales thanks to massive debts, but another company may have lower sales figures, but they’re debt-free.
Value investing metric #3: Price-to-earnings-growth ratio
The price-to-earnings-growth ratio gets worked out by dividing a company’s price-to-earnings ratio against its expected earnings growth rate.
For example, a company has a price-to-earnings ratio of 20. They expect an earnings growth rate of 10%, which means their price-to-earnings-growth ratio is 2.0. What makes this investment metric important?
It’s helpful because some companies operating in the same industry are hard to compare using just the price-to-earnings ratio if they are at different stages. However, using the price-to-earnings-growth ratio, you can better compare the two companies as you factor in their projected future earnings.
Here is an example of how the price-to-earnings-growth ratio can assist in comparing two companies:
The first company trades for 15 times earnings. And the second trades for 20 times earnings. A quick glance at this means the first company may seem like the better investment.
Once growth gets factored in, the picture quickly changes. For example, the first company expects 10% growth, and the second company anticipates 15% growth.
To calculate the price-to-earnings-growth, we must divide the price-to-earnings ratio and the expected growth.
The first company has a price-to-earnings-growth rate of 1.5 (15/10), and the second company has a rate of 1.3 (20/15).
Now you can see although the second company had a higher price-to-earnings ratio, it is the second company that is the cheaper of the two once growth gets factored in.
Value investing metric #4: Profit margin ratio
The profit margin ratio is a company’s profit divided by its revenue. Using this investment metric can assist with how well a company handles its finances as it compares profits to sales.
Value investors can use the profit margin ratio to determine how well a company converts sales into net income. From an investment point of view, it’s essential to know that profits are high enough to pay dividends.
If the profit margin is low, then this would suggest expenses are high and could mean that dividends don’t get distributed. As an investor, seeing that the company is well-managed with enough profit to pay dividends can help you know it’s a sound investment.
Value investing metric #5: Payout ratio
The payout ratio is determined by dividing the company’s annual dividend rate by its earnings. It’s a crucial stock metric to use as it can help figure out those stocks that may seem to be surprisingly better than other metrics would suggest they should be.
For example, a dividend of $1 and annual earnings of $4 would mean a payout ratio of 25%.
Value investors know a reasonable payout ratio is different for each industry. But, generally speaking, the closer a payout ratio is to 100% or higher, the less stable a future dividend could be.
Value investing metric #6: Debt-to-equity
Too much debt can be devastating for a company in the event of an economic crisis. Many companies going out of business often have a large amount of debt.
The debt-to-equity ratio is calculated by dividing a company’s total liabilities by its shareholders’ equity as found on its balance sheet.
Different industries have different standards for acceptable levels of debt. Once value investors know the debt-to-equity ratio, they can see if the debt is acceptable to that industry or if it relies on excessive debt to fund its operation.
Value investing metric #7: Free cash flow
Earnings don’t always equal the amount of cash that is flowing into a company. In addition, some accounting items such as depreciation can make a company’s earnings seem higher or lower than they are.
Looking at a company’s free cash flow helps you see how much money the company is generating. Free cash flow is calculated by looking at a company’s cash flow statement and deducting its capital expenditures from its cash flow operations.
The benefit of looking at a company’s free cash flow is that value investors can understand why a company’s price-to-earnings ratio looks cheap or expensive.
For example, for the fiscal year ending 2020, a company reported an operating cash flow of $1 million. However, in that fiscal year, the company spent $600,000 on new equipment. As a result, the free cash flow the company has is $400,000.
Working out the free cash flow can tell you a lot about the status of the business. A large amount of free cash flow shows that the company has plenty of money left over. And, that excess money can get used for many things, including paying dividends.
How to Assess These Financial Indicators
When searching for stocks to buy, it is essential to use several of these investment metrics when choosing which investments are right for you.
Using just one metric, such as the price-to-earnings ratio, won’t give you enough data to make an informed choice. Other factors like debt-to-equity, free cash flow, and dividend payout ratio will help provide a clearer picture of the investment overall.
When comparing two companies in the same industry, it is also essential to check the price-to-earnings-growth ratio. This is beneficial as companies at different points in their business life may not be comparable when looking at the price-to-earnings ratio.
Use all the data available, as the more you know, the better investment decision you can make. Of course, all investments carry an element of risk, but this can be minimized by doing thorough research beforehand.
Making Your Investment Decisions
The first thing you must do before making any investment decision is to create a plan. Ask yourself the following questions: What are my financial goals? How much am I willing to risk?
Once you have answered these questions and created a financial plan either by yourself or with the help of a professional, you can start making investment choices that get tailored towards reaching your goals.
Another benefit of having a plan is it allows you to decide your risk profile. For example, higher-risk investments have great rewards but could see significant losses–high-risk investments can be great as part of a long-term plan when you have time to recover from any financial shocks.
Diversifying your investments is also highly recommended. For example, you could put all of your investments into one low-risk stock. This may mean you may not suffer losses, but you’ll probably not receive great returns either.
Aim to strike a balance between high-risk and low-risk investments so that you can maximize your returns.
When making your investment decisions use all the data you can from the stock metrics along with your financial plan, and you will, hopefully, make sound investment choices that will give you fantastic returns.
Using the above investment metrics will help you build up a picture of your investment and whether it is likely to be profitable. However, nothing is 100% certain. If it were, we would all be fabulously wealthy by now!
Instead, the goal is to make sound investments that can provide good returns over many years.
To do this, look at several of the ratios and the company’s stock valuation, earnings, and financials to get an accurate picture of the investment potential. Doing all this will help you make better investment decisions.
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