Wondering how to understand stock metrics to analyze a good stock? Many investors struggle with this at some point. I mean, when stocks are crashing, even I’ve found myself asking, is December 1, 2022 the time to get in? And when stocks are at their all-time highs, maybe it’s too late. So, how do we analyze stocks to find out when is a good time to buy? With metrics – that’s how!
In this article, I’m going to cover 8 of the most popular stock metrics investors use to analyze stocks.
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. Not only that but utilizing stock analysis tools can be a huge game-changer as well.
When I first started investing, I would often be put off by confusing terminology and statistics about stocks. And would base my portfolio arrangement on consensus, web research, word of mouth, and sometimes even a little guesswork.
Let’s dive into some of the most common metrics of 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 go on to be big winners.
Stock Metrics Explained
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 financial architects 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 will not 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 do not 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 investment opportunities.
The various investment metrics do not guarantee success. However, they provide you with the knowledge of whether a stock is likely to give you a return.
Expensive stocks could take 2 or 3 years to appreciate further. Any stocks trading lower than a company’s fair value are probably lower for a reason – the stock market is efficient! You must know why the stock gets discounted and what is needed for the price to appreciate before you can judge when the investment is worth it or not.
8 Stocks Metrics To Know By Heart
Stocks can be analyzed using a variety of measures. The eight metrics listed here are some of the most popular stock metrics you can use to find outstanding investment opportunities.
Earnings per share tell us how much net earnings a company has, for each share. For example, if you had a company with $100 in net earnings and 2 shareholders. Then, the company would be said to have a $50 earnings per share ratio.
Let’s consider Microsoft stock. At the time of this writing, their EPS is $9.39. This means the company makes $9.39 in net profit for each share that’s issued. So, the higher the EPS, the higher the company’s profitability.
Now, if a company loses money, for example, during a recession, the company would have negative EPS. It doesn’t necessarily mean it isn’t a good stock, or that you should sell it. But, it’s important to know why they are losing money, and how management plans to turn the company around.
Take, for example, WeWork. This company’s current EPS is negative 18.38. In other words, for every share issued, the company actually loses $18.38. That said, if the company can grow the business, and cut expenses, that EPS could turn positive and the stock could soar.
EPS ratio is also an important metric to know when analyzing other stock metrics as well, such as the PE ratio.
Metric #2: Price-earnings ratio (PE)
One of the essential stock metrics is the price-earnings ratio. To calculate PE, you take a company’s current stock price and divide it by the earnings per share.
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. And, all while 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 would not be as helpful because they are in different industries.
Metric #3: Price/earnings growth (PEG) ratio
The price-to-earnings-growth (PEG) 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 stock metric important?
It is 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 PEG, 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.
Metric #4: Price-to-sales (P/S)
The price-to-sales ratio gets calculated by dividing a company’s stock price by its sales per share – or revenue per share.
One benefit of using this ratio is that it helps you compare companies that cannot 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 are still worth investing in.
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. However, another company may have lower sales figures, but they are debt-free.
To calculate market capitalization, multiply the current share price by the shares outstanding. For example, ABC Company has 1 million shares outstanding at $10 per share. This means the market cap is $10 million.
Metric #5: Profit margin ratio
To calculate the profit margin ratio, divide a company’s profit 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 is 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 the company might not pay dividends. As a dividend investor, this is important.
Metric #6: Payout ratio
To calculate the payout ratio, divide the company’s annual dividend rate by its earnings. It is 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.
Metric #7: 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.
To calculate the debt-to-equity ratio, divide 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 this stock metric, they can see if the debt is acceptable to that industry or if it relies on excessive debt to fund its operation.
Metric #8: Free cash flow (FCF)
Earnings do not 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.
To calculate free cash flow, deduct capital expenditures cash flow operations from the company’s cash flow statement.
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, let’s say a company reported free cash flow of $1 million for the last five years. One might say the company is stable. But what if customers stopped paying their bills, or if inventory was increasing. FCF would help identify these weaknesses.
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, the company can use that excess money 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, will not 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, investors can minimize this 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 know the answers to these questions and have a financial plan with the help of a professional, you can start tailoring investment choices based on your goals.
Another benefit of having a plan is it allows you to decide what risk profile you are comfortable with. 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.
Financial advisors almost always suggest diversifying your investments. For example, you could put all of your investments into one low-risk stock. This may mean you may not suffer losses, but you will 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 stock 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.