Stock Valuation Metrics 101

Growth investors often ignore price-to-earnings ratios. Value investors might skip out on stocks with a high dividend yield even though the price-to-earnings ratio may seem attractive. Confused about how to think about these metrics? Brian Feroldi shares his insights on a Fool Live episode recorded on Jan. 14 and explains why some metrics are better than others depending on the phase of the company's life cycle. 

Brian Feroldi: This one is one of the ones that trips up so many investors. It really trips you up when you are a new investor until you understand what a company looks like as it grows. When I first learned about the price-to-earnings ratio, I just applied it to everything. I couldn't understand why David Gardner was recommending so many stocks that had astronomically high P/E ratios, and getting them right. It was like, "This company has a PE ratio of 400. I think it's a great buy." That just did not compute in my head how that can be possible.

But once you understand operating leverage, and the phases of a business, you come to learn when valuation metrics are useful, and when they are useless. There's a lot going on with this slide, if you've never seen it before. This just goes through the life cycle of a company. Phase 1 is R&D. There's no revenue coming in. The company is just all about the future, and there's no valuation metric that you can look at here to say, this is a good one. You are literally betting on the founder, you are betting on the idea, you're betting on the management team. It's all hope.

After that product is brought to market and launched, they're starting from revenue of zero. Because of that, the only metric that you can really look at then to judge your success is the price-to-sales ratio. Oftentimes they are reinvesting so aggressively back into the business that their gross margin is low, their expenses are ballooning as they scale to build out their commercial team, and their earnings are negative.

Once they pass with the launch phase, and they prove out that they have nailed product-market fit, that's when they crossover into break-even. That's a super confusing time for a lot of investors because it looks like their price-to-earnings ratio is in the hundreds or thousands of a number. When you see that, you're like, well, this makes no sense. It's going to take them 1400 years for me to get my money back on buying this company.

But what I didn't realize at that time when I first was doing this was that, the PE ratio is super high because the "E" is artificially low. The company is optimizing itself for profits, but it's not yet there. For example, if a company is eventually going to get to a 10% profit margin, so for every dollar in sales, they keep 10 cents, and they're currently at half a percent of profit margin, the PE ratio is artificially low by a factor of 20. If their earnings yield is half of one percent, that's their current profit margin, and they eventually can get to 10 percent, that's a 20-fold increase. Because of that, their P/E ratio is overstated by a factor of 20.

That I didn't understand before. But as they continue to scale themselves, that's when you see operating leverage kick in, and their profit margin expand. Once their margin profile is fully built out, they enter the mature phase. From there, their earnings growth is no longer driven by operating leverage, it's driven by revenue growth, stock buybacks, and oftentimes small, little changes to margin. At that stage, and only at that stage is the price-to-earnings ratio usable.

The price to earnings ratio works great on Apple (AAPL -0.57%), on Microsoft, on Google, on companies that are fully optimized for profits. Don't use the price-to-earnings ratio, which should be used in Stage 4, on a company that's in Stage 2. Because it will just throw you off and it will give you a false number. This is something that kept me out of many great growth stocks at the time, even though they were highly recommended by people that I respected, simply because I said, P/E ratio, too high. It makes no sense.

Conversely, when you get into Stage 5, when you are in a serial state of decline, don't get suckered into high dividend yield and low P/E ratio. Because if earnings are heading toward zero, those numbers are irrelevant.

Brian Withers: That's a great point, Brian. I love this chart. Figuring out where companies are is really important and in thinking about them in your head, and how you want to invest.

Feroldi: Totally.