When evaluating stocks, there are literally hundreds of different metrics you can use to judge the financial chops of an individual company. We Fools certainly do not believe that you need to have them all mastered before you can begin investing, but we do feel that there are a handful that matter a great deal.
We asked our team of Motley Fool contributors to explain an investing metric that they believe both new and seasoned investors should fully understand before they commit any capital to the market. Read below to see what they had to say.
Matt Frankel: One metric I always look at when making an investment is the interest coverage ratio, which is also referred to as "times interest earned."
The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense on its outstanding debts. This lets us know how many times over a company could pay its interest obligations based on its current earnings. For example, a company with EBIT of $4 million and interest expense of $1 million would have interest coverage of 4 times.
This is an important aspect of a company's financial condition because it reveals the company's margin of safety to absorb adverse conditions and not have to dip into its reserves or borrow even more to cover interest payments.
In general, I look for companies with a minimum interest coverage of 2.5 times, but higher than this is preferable. For example, one of my portfolio's core holdings, Realty Income (NYSE:O), has interest coverage of 4.2 times. What this implies is that even if an economic catastrophe wiped out 76% of Realty Income's EBIT, the company could still afford to pay its creditors.
Another metric worth knowing is fixed-charge coverage, which is similar to interest coverage, but includes all of a company's fixed expenses such as preferred stock dividends, agreed upon debt principal payments, and lease expenses.
Knowing a company's interest and fixed-charge coverage can give you a good idea of how financially solid a company is, as well as its ability to make it through the tough times.
Brian Feroldi: While there are plenty of metrics that can be used to measure the value of a company that's mature and profitable, it harder to measure the worth of a company that hasn't begun to earn a profit. For these companies it can be useful to look at the price-to-sales ratio, which is calculated by dividing a company's market capitalization by its combined revenue from the last four quarters.
The price-to-sales ratio shows how much investors are paying for $1 dollar in sales for a company, and while this number varies depending of the company's sector, it's nevertheless a good measure of value.
Take Amazon (NASDAQ: AMZN) as an example. Since the company is constantly plowing its profits back into the business to drive growth, its P/E ratio is next to useless in determining value. However, if you look at the price-to-sales ratio for Amazon you get a better idea of its valuation.
Here's Amazon's price-to-sales ratio over the last five years:
This metric was near a five-year low at the beginning of the year, implying its shares were a good value at the time. The market seems to have agreed with that assessment, as Amazon's shares proceeded to climb by 111% year to date! Currently Amazon stock is trading at a five-year high when looking at this metric, which could indicate that shares are expensive at the moment.
No single metric is enough to determine the value of a business, but I think the price-to-sales ratio is one all investors should know.
Adam Galas: Investors often focus on the earnings payout ratio to determine if a specific company's dividend or buyback program is sustainable, but the free cash flow payout ratio is a better metric to use.
This is because earnings typically include numerous noncash charges, such as depreciation, amortization, and one-time events like write-offs or profitable asset sales. These charges can cause earnings to swing wildly and make determining the long-term viability of a capital-return program unreliable.
Conversely, free cash flow represents how much actual money a company has left over after paying expenses and investing to grow sales. Thus, while earnings is a way of keeping score, free cash flow is what actually runs a business and funds its buybacks and dividends.
Apple (NASDAQ: AAPL) provides a good example. Over the past year, its earnings were $53.4 billion while it paid out $11.6 billion in dividends and bought back $35.3 billion in stock.
Using the earnings payout ratio, it looks like Apple is returning 88% of profits to shareholders. That's a high level because it means that should sales and profits dip it might make the capital-return programs unsustainable.
However, Apple's free cash flow over the last 12 months was actually $69.8 billion. That means its free cash flow payout ratio is only 67%. Thus, we can see that Apple's shareholder cash return bonanza is actually very sustainable, even if sales were to stop growing or decline substantially.
Selena Maranjian: One investing metric that's worth understanding is the gross margin. There are actually three key profit margins that you can determine from a company's income statement: gross margin, operating margin, and net margin. Start at the top with total revenue and then subtract the cost of goods sold ("COGS"), which represents the direct cost of producing the company's products and/or services. You're left with the gross profit. Divide that by total revenue and you'll get the gross profit margin.
Different industries and businesses tend to have different ranges of gross margins. Compare the gross margins of peers and you can see how well a company is competing against its closest rivals. For example, Chipotle Mexican Grill's (NYSE:CMG) gross margin was recently near 28%, while that of McDonald's (NYSE:MCD) was 38%, showing that it costs more for Chipotle to produce its offerings, which is not surprising given that it differentiates itself as offering higher-quality ingredients.
You can move further down the income statement to learn more. From the gross profit, operating costs (such as support staff salaries, utility bills, and advertising expenses) are subtracted, leaving the operating profit. Divide that by total revenue and you'll get the operating margin, which reflects another level of efficiency. Finally, to reach the bottom-line net profit margin, we subtract expenses such as taxes and interest payments from operating profit to arrive at net income (or a net loss). Divide that by total revenue to get the net margin. That reflects how much of every dollar of sales a company gets to keep as profit. In our quick-serve example, McDonald's has the higher net margin. Low margins aren't deal-breakers, though, if they're coupled with high volume. You can learn a lot in the margins.
Sean Williams: There's perhaps no more widely followed fundamental metric than the price-to-earnings, or P/E, ratio. When discussing "value," it's the tool that most investors will pull out of their pocket. But P/E ratios have one fundamental flaw: they're backward looking, which does us no good in a market that's always looking to price stocks based on their long-term outlook. That's why we have what I believe to be one of the most important metrics at our disposal: the price/earnings-to-growth ratio, or PEG ratio.
PEG ratios take into account a company's current valuation, its P/E ratio, and most importantly its expected future growth rate. This allows investors to determine not only whether a company is valued attractively based on its previously reported earnings results, but if it's trading at a possible discount to future growth. As an example, a stock with a P/E of 15 and a five-year growth rate of 10% would have a PEG ratio of 15 divided by 10, or 1.5.
What's an attractive PEG ratio you ask? It all depends on the industry, but the unwritten rule is that anything with a PEG ratio below two could be considered attractive in the right light, while anything above two might be fairly valued or overpriced. Personally, I like looking for companies with a PEG ratio around one if I'm really seeking out a value stock. I'd suggest running a stock screen of your favorite sector or industry and using PEG ratios as the filter to begin your research.
Adam Galas has no position in any stocks mentioned. Brian Feroldi owns shares of Amazon.com, Apple, and Chipotle Mexican Grill. Matthew Frankel owns shares of Realty Income.. Sean Williams has no position in any stocks mentioned. Selena Maranjian owns shares of Amazon.com, Apple, Chipotle Mexican Grill, and Realty Income. The Motley Fool owns shares of and recommends Amazon.com, Apple, and Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.