Whether you're a new investor or a seasoned veteran, there are probably a handful of metrics you don't understand, or maybe you're no sure what they're for. Frankly, there are a lot of metrics out there that are just plain worthless. Why? Because they don't really give you any information about a company's stock value relative to its earnings power.
With this in mind, we asked some of our contributing writers to describe a metric they think you can safely ignore. Here's what they told us.
Dan Caplinger: One of the most often-followed metrics for a company is its market capitalization, which equals the number of shares it has outstanding multiplied by its current share price. A host of other measures of a stock's success come from its market capitalization, and most people judge the overall size and scope of a company's reach through its industry by its market cap.
The problem, though, is that the market cap only considers one measure of the size of the company: the piece of its capital structure that's financed by equity. To get a more complete picture of how large a company really is, it's helpful to include the portion of the capital structure financed by debt. That's what enterprise value measures.
Specifically, companies with large amounts of debt have far more influence than their market capitalizations would suggest. Mortgage real-estate investment trust Annaly Capital (NYSE:NLY), for instance, has a market cap of just $9 billion. But when you add in the debt it has, Annaly's size balloons to an enterprise value of nearly $75 billion.
For all the attention market cap gets, enterprise value is an often-overlooked but useful measure of a company's size. Look beyond market cap and see how enterprise value can make comparing different companies fairer.
Jordan Wathen: There are many financial ratios I never really liked, but the price-to-sales ratio sticks out like a sore thumb as one of the worst.
The glaring issue is that sales aren't profits. Sales are simply sales, and speak little to the value of a company. After all, you could build a huge company overnight by selling $1.00 bills for $0.99, but you'd go broke doing it.
More academically, the price-to-sales ratio lacks in that it takes the market price of the outstanding stock only and divides it by sales, which support equity and debt. If you like this metric, and insist on valuation based on sales, a more appropriate ratio would be the enterprise value to sales, as it accounts for debt in the capital structure, as Dan mentioned above. The price-to-sales ratio makes highly leveraged companies appear cheaper than they really are, since equity makes up a smaller part of their capital structure.
Jason Hall: Probably the most important metric to ignore is the one we all look at the most: stock price. Seriously -- hear me out.
On its own, a stock price is a useless measure. It doesn't tell anything of importance. For instance, take two well-known bank stocks, Bank of America and U.S. Bancorp:
Going just on the stock price, it would be easy to assume that Bank of America was the "cheaper" stock, but that's not necessarily the case. U.S. Bank's share price is so much higher largely because there are 1.7 billion shares of its stock, while Bank of America has 10.5 billion shares outstanding. That's about 83% fewer shares of U.S. Bank stock. So, even though B of A is more than twice as large as U.S. Bank, all of those extra shares make its stock price lower.
It's because of this variance in every company's stock price and market value that a stock's price in and of itself doesn't give you anything usable with which to value a company. A useful metric for comparing companies within the same industry will "normalize" the stock price between the companies, and will usually factor in things like debt and earnings -- which, as Dan and Jordan describe above, are ignored by many metrics. A ratio like EV to EBITDA -- also called the enterprise multiple -- paints a different "value" picture for the two banks:
EV to EBITDA measures a company's Enterprise Value, which is the the total value of all of the shares held by investors (both common stock, preferred, or minority interests), plus the company's total debt, minus cash and equivalents. Divide this number by the company's EBITDA, which is earnings before interest, taxes, depreciation, and amortization (which basically measures the cash-generating power of the core business).
As you can see above -- since a lower number indicates a "cheaper" stock -- U.S. Bank shares are actually "cheaper" based on this metric.
Putting it all together
As our experts demonstrated above, you might be relying on a metric today that's not really helping you invest better, especially if that metric fails to help you determine if the price you'd pay for the stock is good or not, based on the company's ability to make a buck.
Okay, Fools, your turn: Is there an even more useless metric that we missed? Tell about your least favorite metrics in the comments below.
Dan Caplinger has no position in any stocks mentioned. Jason Hall owns shares of Wells Fargo. Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America and Wells Fargo. Try any of our Foolish newsletter services free for 30 days.