Different metrics can give you insight into the different parts of a company’s operations and financial standing. On the outside, things may seem to be running well, but you’ll often find that looking at a company’s financial statements will reveal that everything that glitters is not gold.
This doesn’t mean you need to know a company’s finances from front to back, but there are a few metrics you’ll want to have an idea of before deciding to invest.
1. Price-to-earnings (P/E) ratio
The P/E ratio is a simple metric to use when it comes to spotting undervalued or overvalued companies. Instead of looking strictly at a stock’s price — which can be misleading because there are “expensive” $20 stocks and “cheap” $500 stocks — the P/E ratio gives you a better idea of the value of a company. You can find the P/E ratio by dividing its stock price by its earnings per share (EPS).
You can’t really use a company’s P/E ratio alone; you need to compare it to other companies within the same industry. Comparing companies from different industries is oftentimes like comparing apples to oranges. For example, Apple recently had a P/E ratio of around 24, and Microsoft had a P/E ratio of 28.5. If you want to know whether Delta Air Lines, which had a P/E ratio of 53 recently, is undervalued, it would be misleading to compare it to them.
2. Debt-to-equity ratio
It’s common for businesses to finance their operations by taking on debt, but when debt levels become too high, that’s a red flag. A company’s debt-to-equity ratio lets you know how much of its business operations are financed through debt versus money invested by owners and retained earnings. To calculate the debt-to-equity ratio, divide total debt by shareholder equity. The higher this ratio, the more risk the company is taking on.
If a company has $100,000 in debt but $1 million in equity, its debt-to-equity ratio is 0.1, and it’s 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 is almost entirely funded by debt.
While you typically want a lower debt-to-equity ratio, an extremely low ratio could mean the company is being too conservative and keeping too much money instead of using it to continue trying to grow. Whether it’s research and development, logistics, or acquisitions, these things can contribute to a company’s growth, but it can’t happen without spending money. Being cheap now can be costly in the future.
3. Dividend payout ratio
If you’re interested in investing in a dividend-paying company, you need to be aware of the company’s dividend payout ratio, which tells you how much of its earnings it’s paying out in dividends. To calculate the dividend payout ratio, divide a company’s yearly dividend by its EPS. If a company’s yearly dividend is $5 per share and its EPS is $20, its payout ratio would be 25%.
If a company has a dividend payout ratio of 100%, that means it’s paying out all of its earnings in dividends; if it has a ratio over 100%, that means it’s paying out more than it has coming in — which, as I’m sure you can guess, is not a good thing. As a rule of thumb, having a payout ratio between 30% to 50% is a good mix of rewarding shareholders and reinvesting enough into the business.
Generally, younger companies don’t pay out dividends because they need to reinvest that money into the company to continue growing. Older, more established companies have less room for hypergrowth, and it’s less likely you’ll see exponential growth in their stock price. To compensate for that, they pay dividends to reward shareholders for holding on to their stock.
For many investors, dividends will make up a good portion of their total return. Be sure to know a company’s dividend payout ratio, so you know if it’s sustainable in the long run.
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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 Delta Air Lines and 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.