When analyzing a company, there are many metrics you can use to get insight into its operations and financial health. If you look at a company’s financial statements, you can find everything from its profit to expenses to debt and much more. Here are what these three metrics tell you about a stock.
1. Price-to-earnings (P/E) ratio
You shouldn’t look at a stock’s price by itself to determine whether it’s cheap or expensive; it could very well be the case that a $15 stock is expensive and a $1,500 stock is cheap. Investors should use metrics like the price-to-earnings (P/E) ratio to determine whether a stock is a good value at its current price. The P/E ratio compares a company’s stock price to its earnings per share (EPS), and it’s one of the best ways to determine if a business is overvalued or undervalued.
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When using the P/E ratio, it’s important to compare companies within the same industry. Comparing Apple‘s P/E ratio 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’s likely undervalued.
2. Free cash flow
Although it seems similar to profit, free cash flow is a different metric that typically measures how much money a company has coming in after accounting for capital expenditures. For investors, a company’s free cash flow can give insight into its financial health as well as its potential. The potential comes because free cash flow is what businesses use for activities like paying out dividends, repaying debts, buying back shares, or even making acquisitions.
With no (or negative) free cash flow, a company might have limited capital to use on these key activities. Free cash flow is particularly important to know for investors who want to invest in companies that pay dividends. If a company is paying out more in dividends than itsfree cash flow, that’s usually not a good sign. A strong free cash flow is a sign of a financially sound company.
3. Debt-to-equity ratio
You can find a company’s debt-to-equity ratio by dividing its total debt by shareholder equity. This figure lets you know how much of a company’s operations are financed through debt, and generally, the higher the ratio, the more risk the company is taking on. Some industries, by their nature, require more debt than others. That’s why it’s best to compare debt-to-equity ratios among 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 dividend during rough economic times. If a company takes on debt to keep its dividend going, that’s a red flag. Financially healthy companies should be able to pay out dividends from their profits, not from taking on debt.
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Stefon Walters has positions in 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 a disclosure policy.