With that in mind, let’s take a look at five of the most important and easy-to-understand metrics you should have in your analytical toolkit:
- Price to earnings (P/E) ratio — Publicly traded companies report their profits to shareholders as earnings per share, or EPS for short. If a company earned $10 million and has 10 million outstanding shares, its EPS would be $1.00 for that time period. The price-to-earnings ratio, or P/E ratio, is a company’s current share price divided by its per-share earnings, typically on an annual basis. For example, if a stock trades for $30.00 and the company’s earnings were $2.00 per share over the past year, we’d say it traded for a P/E ratio of 15, or «15 times earnings.» This is the most commonly used valuation metric in fundamental analysis, and is most useful when comparing companies in the same industry with similar growth prospects.
- Price-to-earnings growth (PEG) ratio — This metric takes the P/E ratio a step further. Different companies grow at different rates, so it’s important to take this into consideration. So, the PEG ratio takes a stock’s P/E ratio and divides by the expected annualized earnings growth rate over the next few years. For example, a stock with a P/E ratio of 20 and 10% expected earnings growth over the next five years would have a PEG ratio of 2. The idea here is that fast-growing companies can be «cheaper» than slower-growing companies, even if their P/E ratio makes them look more expensive.
- Price-to-book (P/B) ratio — A company’s book value is the sum of the value of its assets. Think of book value as the amount of money a company would theoretically have if it shut down its business and sold everything it owned – tangible property as well as things like patents, brand names, etc. The price-to-book, or P/B ratio, is a comparison of a company’s stock price to its book value. Like the P/E ratio, this is most useful for comparing companies in the same industry that have similar growth characteristics and should be used in combination with other valuation metrics.
- Return on equity (ROE) — One of the most commonly used profitability metrics, return on equity or ROE is calculated by dividing a company’s net income by its shareholders equity (assets minus liabilities). In a nutshell, ROE tells us how efficiently a company is using its invested capital to earn a profit, and like most metrics, is useful for comparing companies in the same industry. In other words, you could consider a company with a 20% ROE to be more efficient at generating a profit than one with a 10% ROE.
- Debt to EBITDA — A company’s financial health should also be taken into consideration when analyzing its stock, and one good way to gauge financial health is by looking at the company’s debts. There are several debt metrics you can use, and the debt-to-EBITDA ratio is a good one for beginners to learn. You can find a company’s total debts on its balance sheet and its EBITDA (earnings before interest, taxes, depreciation, and amortization) on its income statement. There’s no set rule in regards to how much debt is too much, but if a company’s debt to EBITDA is significantly higher than its peers, it could be a sign of a higher-risk investment.