Different metrics can give you insight into different parts of a company’s operations and financial health. On the surface, things may appear to be going well, but you will often find that looking at a company’s financial statements, it’s not gold that shines.
That doesn’t mean you need to understand the company’s financials from start to finish, but there are some metrics you need to know before deciding to invest.
1. Price-to-earnings ratio (P/E)
The price-to-earnings ratio is a simple metric when it comes to spotting undervalued or overvalued companies. Unlike looking strictly at stock prices – which can be misleading because there are “expensive” $20 stocks and “cheap” $500 stocks – the P/E ratio can give you a better idea of what a company is worth. You can calculate the price-to-earnings ratio by dividing its share price by its earnings per share (EPS).
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You can’t really use a company’s P/E ratio alone; you need to compare it to other companies in the same industry. Comparing companies from different industries is often like comparing apples and oranges. E.g, apple The most recent price-earnings ratio was about 24, and Microsoft The price-earnings ratio is 28.5.If you want to know if Delta Air LinesThe recent P/E ratio of 53 is undervalued, and comparing it to them would be misleading.
2. Asset-liability ratio
It’s common for businesses to take on debt to finance their operations, but when debt levels become too high, it’s a red flag. A company’s debt-to-equity ratio gives you an idea of how much of its business operations is financed by debt versus owner-invested funds and retained earnings. To calculate the debt-to-equity ratio, divide total debt by shareholders’ equity. The higher this ratio, the more risk the company takes.
If a company has $100,000 in debt but $1 million in equity, it has a debt-to-equity ratio of 0.1 and is considered a low-debt company. If the two were reversed, and the company had $1 million in debt and $100,000 in equity, the debt ratio would be 10, meaning the business was financed almost entirely by debt.
While you generally want a low debt-to-equity ratio, an extremely low ratio can mean the company is being too conservative and holding onto too much money, rather than using it to continue struggling to grow. Whether it’s R&D, logistics, or acquisitions, these things can contribute to a company’s growth, but not without spending money. Cheap now may be costly in the future.
3. Payout ratio
If you’re interested in investing in a company that pays dividends, you need to know the company’s dividend payout ratio, which tells you how much of its earnings it has paid out in dividends. To calculate the dividend payout ratio, divide a company’s annual dividend by its earnings per share. If a company pays $5 per share in annual dividends and earns $20 per share, its payout ratio is 25%.
If a company has a dividend payout ratio of 100%, it means it pays out all its earnings in the form of dividends; if its ratio exceeds 100%, it means it pays out more than it comes in – I’m sure you can guess , which is not a good thing. As a rule of thumb, a payout ratio of between 30% and 50% is a good mix of returning shareholders and adequately reinvesting in the business.
Generally, younger companies don’t pay dividends because they need to reinvest the money into the company to continue growing. Older, more established companies have less room for hypergrowth, and you’re less likely to see their stock prices grow exponentially. To compensate for this, they pay dividends to reward shareholders who hold shares.
For many investors, dividends will account for a large portion of their total returns. It’s important to know a company’s dividend payout ratio so you know if it’s sustainable over the long term.
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Stefan Walters has positions at Apple and Microsoft. The Motley Fool has positions at Apple and Microsoft and recommends them. The Motley Fool recommends Delta Air Lines and recommends the following options: March 2023 Apple long-term call at $120 and March 2023 Apple short-term call at $130. The Motley Fool has a disclosure policy.