When analyzing a business, there are many metrics you can use to gain insight into its operations and financial health. If you look at a company’s financial statements, you can find everything from its profits to expenses to debts and much more. Here’s what these three metrics tell you about a stock.
1. Price-to-earnings ratio (P/E)
You shouldn’t look at a stock price per se to determine if it’s cheap or expensive; it may well be the case that a $15 share is expensive and a $1,500 share is cheap. Investors should use metrics like the price-to-earnings (P/E) ratio to determine if a stock is a good value at the current price. The P/E ratio compares a company’s share price to its earnings per share price. Stock (EPS), and it’s one of the best ways to determine if a company is overvalued or undervalued.
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When using the P/E ratio, it is important to compare companies within the same industry. Compare Apple‘s P/E relationship to ExxonMobil‘s, for example, probably wouldn’t return the best insight. Instead, it would make more sense to compare Apple to Microsoft. As a rule of thumb, if a company’s P/E ratio is significantly lower than that of other comparable companies, it is likely to be underestimated.
2. Free cash flow
Although similar to profits, free cash flow is another metric that typically measures how much money a business has for after taking capital expenditures into account. For investors, a company’s free cash flow can provide insight into its financial health as well as its potential. The potential comes because free cash flow is what companies use for activities like paying dividends, repaying debt, buying back shares, or even making acquisitions.
Without (or negative) free cash flow, a corporation may have limited capital to spend on these key activities. Free cash flow is especially important to know for investors who want to invest in companies that pay dividends. If a company pays out more in dividends than its free cash flow, that’s usually not a good sign. A strong free flow of money is a sign of a financially sound business.
3. The debt-to-GDP ratio
You can find a company’s debt ratio by dividing its total debt by equity. This number tells you how much of a company’s operations are funded through debt, and generally, the higher the ratio, the more risk the company assumes. Some industries inherently require more debt than others. Therefore, it is best to compare debt ratios between companies within the same industry to get a sense of which ones have problematic debt levels.
For dividend-paying companies, having a lot of debt increases the chances that they might have to cut their dividends in tough economic times. If a company takes on debt to keep its dividends going, that’s a red flag. Financially sound companies should be able to pay dividends on their profits, not on taking on debt.
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Stefon Walters holds positions at Apple and Microsoft. The Motley Fool has positions in and recommends Apple and Microsoft. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has an enlightenment policy.