Investors use a number of different financial ratios to evaluate individual companies. In many cases, the best ratios for evaluating a company differ depending on the particular industry in which the company does business. In comparing financial ratios, it's critical to use ones that accurately reflect value, or else you'll run the risk of drawing bad conclusions from your analysis. Below, we'll go through some popular financial ratios and whether they work in comparisons to a broader industry.
Valuation and the price-to-earnings ratio
The P/E ratio is the most commonly used metric of valuation among individual investors. High P/E ratios indicate a more expensive stock, while lower P/E ratios are seen as a sign of value. Many investors find that P/E ratios in certain industries are much different from others, making it essential to use industry averages rather than broad stock market average P/E figures.
Even within an industry, though, there can be wide variation in P/E. The most important reason is when growth prospects differ inside a particular industry. For instance, in technology, some companies specialize in high-growth areas while others focus on commodity-like low-growth areas. P/Es for the typical low-growth stock should be much less than a high-growth counterpart, even if they're in the same industry. Just because a low-growth stock has a low P/E doesn't mean that it's a better value than the more expensive high-growth stock.
Income investors look at dividend yield to determine how much cash a stock investment will provide shareholders. Again, some industries tend to pay higher dividends than others, but even within an industry, dividend yields can differ greatly.
Looking only at dividends can lead you to make the wrong conclusion about a stock. For instance, if a company chooses to retain earnings for whatever reason -- whether it be to reinvest in its business or simply to keep cash on hand -- then its dividend yield might be lower than a company with the exact same earnings but which decides to share more of those earnings with shareholders through dividend payouts. It's therefore critical to look at measures like dividend payout ratios to get the complete story about a stock.
You'll find many other examples of traps for the unwary in using financial ratios. In the real-estate investment trust arena, investors often compare mortgage REITs based on leverage, but a relatively low-leverage mREIT that invests in non-agency mortgage-backed securities can be riskier than a more highly leveraged mREIT that invests solely in agency-backed debt.
It's tempting to use financial ratios and comparisons to industry averages as a shortcut for full analysis. Don't fall for that trap. To use financial ratios effectively, you have to know the background of the industry and the individual company and be aware of when there are reasons to draw different conclusions from what the raw numbers tell you.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!