One of the biggest problems stock investors often face, whether they realize it or not, is not knowing the best metrics to use when deciding which stocks to choose for their portfolios. For example, a common "rookie mistake" is simply using the price-to-earnings, or P/E, ratio to compare stocks, and basing an investment decision solely on that metric.
With that in mind, here are nine essential metrics that all stock investors should incorporate into their analysis that can help uncover truly attractive investment opportunities.
1. P/E Ratio
No discussion of important investment metrics would be complete without mentioning the P/E ratio. This is a simple metric to calculate -- just take a company's current market capitalization and divide it by its annual earnings.
The P/E ratio tells you how cheap or expensive a stock is, or how much of a premium investors are willing to pay for a company's earnings.
One of the most important things to know about P/E is that it's most useful when comparing companies in the same industry, and with similar growth expectations. For example, comparing the P/E ratios of AT&T and Verizon could make perfect sense as part of your research. On the other hand, comparing the P/E of Amazon.com with that of Macy's wouldn't be too useful.
Dividing a company's market capitalization by its annual revenue gives the price-to-sales ratio. This can be especially useful for comparing companies whose earnings don't tell the full story of how well they're doing, such as high-growth companies that may have negative earnings.
3. PEG ratio
This is one of my favorite metrics to use, because companies are often not enough of an apples-to-apples comparison to make the P/E ratio useful. The price-to-earnings growth ratio, or PEG ratio, helps to level the playing field by taking projected growth into account.
We calculate the PEG ratio by taking a company's P/E ratio and dividing it by its expected earnings growth rate. For example, a company with a P/E of 20 and an expected 10% forward earnings growth rate would have a PEG ratio of 2.0. This can be very useful for comparing companies in the same industry, but in different stages of the business cycle.
Carrying too much debt can be disastrous for companies, especially during tough economic climates. For example, you may have noticed a wave of retail bankruptcies over the past couple of years -- Toys R Us is the latest example. One thing you may not be aware of is that many of the companies that have gone out of business have ridiculously large debt loads.
A company's debt-to-equity ratio is calculated by dividing its total liabilities by its shareholders' equity, both of which can be found on its balance sheet. What constitutes an "acceptable" debt-to-equity ratio can vary considerably among different industries, but this can allow you to compare companies' reliance on debt to fund their operations.
5. Payout ratio
This can be an important metric for evaluating a dividend stock, particularly if you're worried that a dividend might be "too good to be true."
The payout ratio is calculated as the company's annual dividend rate divided by its earnings. For example, a dividend of $1 and annual earnings of $4 translates to a payout ratio of 25%. Acceptable payout ratios vary by industry, but a general rule is that the closer a payout ratio is to 100% (or higher!), the less stable the future dividend could be. With the exception of companies such as real estate investment trusts, which are required to pay out at least 90% of earnings, I tend to look for payout ratios of 60% or less, as well as a solid history of increasing the dividend.
Beta is a measurement of how reactive a stock is, compared to the overall market, generally defined as the S&P 500. A beta of 1 indicates that a stock tends to move in line with the S&P 500 -- that is, a 5% upward move in the index should produce roughly the same move in the stock.
A beta of less than 1 indicates that a stock is less reactive to market swings, while a beta of more than 1 indicates a more volatile stock. For example, if a stock's beta is 0.4, a 10% move in the S&P 500 should theoretically produce a 4% swing in the stock. And a negative beta indicates that a stock tends to move in the opposite direction of the market.
Beta can be found in most stock quotes, and it will give you an idea of how much volatility you're taking on before you buy a stock.
7. Return on equity (ROE)
Return on equity tells you how efficiently a company is using its shareholders' equity to generate a profit. Like many other metrics, ROE is most useful when comparing companies in the same industry, as there can be different "expectations" of profitability. For example, the benchmark ROE in the banking industry is 10%.
ROE is calculated by dividing a company's net income, or earnings, by its shareholders' equity, which can be found on its balance sheet.
8. Free cash flow
Here's something many investors -- even experienced ones -- don't realize. A company's "earnings" don't often equal the actual amount of cash that's flowing in. Without going into too much detail, some accounting items, like depreciation, can distort a company's earnings and make them look higher or lower than they actually are.
Free cash flow tells you how much money a company is really generating. To calculate it, look at a company's cash flow statement and subtract its capital expenditures from its cash flow from operations.
Here's where this can be useful. If a company's P/E ratio makes it look excessively cheap or expensive, calculating the company's free cash flow can help you understand why.
9. Price-to-book (or tangible book)
Price-to-book, one of the most popular metrics among value investors, is a company's stock price divided by its net assets. This metric tells how much investors are willing to pay for a company's assets. Value investors often look for low P/B multiples when searching for bargain-priced stocks.
Using tangible book value in the calculation can be more useful for companies with lots of goodwill and other intangible assets on the balance sheet.
The key takeaway
The most important thing to learn here is that when you're searching for stocks to buy, it's important to use several metrics to compare potential investments, as any single metric, such as the P/E ratio, doesn't give you enough information to make an informed decision. For example, if I were to compare AT&T and Verizon, in addition to comparing P/E, other key factors in my decision could include debt-to-equity, free cash flow, and the dividend payout ratio, just to name a few.