The first valuation metric most investors learn is the price-to-earnings ratio, which is simply a company's stock price divided by its earnings per share over the past year. It's such a popular metric that most finance websites already calculate it for investors. However, while it's the gold-standard valuation metric for most investors, it's always a good idea to have a few more tools in your toolbox when researching stocks.
With that in mind, we asked three of our contributors which valuation metric they thought was the most important. While they all noted the value of the P/E ratio, they thought that price-to-sales, debt-to-equity, and enterprise value-to-EBITDA were even more important. Here's why.
Focus on revenue
Demitri Kalogeropoulos (price-to-sales): There are good reasons the P/E ratio is so popular with investors, given that it neatly captures how many years of profits you're paying to buy a business. When valuing a stable and predictable earnings stream, that metric can speak volumes.
Consider Costco (COST 1.92%), which generates between 1.5% and 2% of sales in earnings each year thanks to membership fees that tend to flow at the same pace despite swings in the broader retailing industry. Investors have decided to pay between 25 and 30 times that profit to own Costco's business, marking a solid premium over its less consistent retailing peers.
But in situations where recent earnings are volatile or unreliable, I'm a fan of price-to-sales. There are many ways a company can swing profit over the short term, but revenue is more difficult to manipulate. Consumer-goods giant Procter & Gamble (PG 1.78%), for example, recently saw its P/E ratio collapse to below 17 -- a 40% decline in the past year. That's mostly thanks to a one-time, $9 billion divestment of a big collection of its beauty brands. On a price-to-sales basis, P&G has become more expensive lately, with investors paying 3.9 times revenue today, compared with 3.5 times revenue a year ago.
With the simple price-to-sales metric in your toolbox, an investor can quickly look behind those unusually high or low P/E numbers to get a more complete picture of a stock's valuation.
An important metric and beyond
Daniel Miller (debt-to-equity): When investors are looking for the next big winner in the stock market, understanding a company's financial health should be a top priority. The debt-to-equity ratio is used to measure a company's financial leverage by dividing a company's total liabilities by its stockholders' equity.
And while that's a great metric that investors should acquaint themselves with, this example is going to go a step further and explain why you truly need to understand the figures you put into the equation. Here's a great example of arguably the world's most misunderstood debt figure, which unfairly inflates Ford Motor Company's (F -3.20%) debt-to-equity ratio when compared with its competitors.
The reason behind the misunderstood figure is Ford Credit, which effectively acts as a bank to lend consumers financing when purchasing a vehicle, among other business objectives. Many of Ford's competitors don't have comparable financial divisions. Because Ford Credit assumes a massive debt load to fund these strategies, and isn't often separated from Ford's total debt sum, which is used in the equation, it's mostly incorrect. For context, at the end of 2016 Ford's total debt load was $142.9 billion, according to Yahoo! Finance, but its automotive debt is a modest $15.9 billion.
Many investors overlook the debt situation at Ford, and let's remember that Ford Credit, which is responsible for the bulk of total debt, is actually Ford's most profitable entity outside its North America region. Debt to equity is a very important metric, but perhaps the most important thing about investing isn't about important metrics; it's about understanding what data you put into them.
Drilling down deeper often tells a different story
Matt DiLallo (enterprise value-to-EBITDA): As Demitri already pointed out, a company's reported earnings can be volatile or even unreliable, which can cause a price-to-earnings ratio to become useless. The energy sector, in particular, is one where a P/E ratio often doesn't tell the correct story. That's because earnings are often artificially low because of large depreciation charges or writedowns resulting from lower commodity prices.
Take pipeline giant Kinder Morgan (KMI -0.10%), which at first glance appears to trade at a nosebleed valuation of 86 times earnings. However, that's because the company recorded several impairment charges and other items last year, which pushed its net income down to $522 million. That's a far cry from the company's underlying earnings of $7.2 billion. And that's why I prefer to use the enterprise value-to-EBITDA (EV/EBITDA) ratio, because it tells the whole story. Not only does it measure a company's underlying cash flow instead of its earnings, but it also compares that cash flow to a company's enterprise value, which takes debt into account. When we use this metric on Kinder Morgan, its valuation ratio falls to 15, which is right in line with other large energy infrastructure companies.
Many businesses use this valuation metric to make buying or selling decisions for a unit or an asset. For example, last year Kinder Morgan sold a stake in one of its pipelines for 11.6 times EV/EBITDA to shore up its balance sheet. While that valuation was less than the 12 to 14 ratio that similar assets had fetched in the marketplace, the company sold the asset for less because it expects to earn a much higher EV/EBITDA multiple on capital invested in future system expansions with the new partner, which will more than make up the difference.
While it takes some extra work to figure out a company's EV/EBITDA ratio, that work is often worth the effort because it gives an investor a more accurate picture of a company's true value.