6 Key Financial Ratios for Investors

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  • A financial metric is a tool that helps investors understand the health of a company.
  • Financial metrics are best used to compare companies within the same industry.
  • Each metric has its own weakness and should be used in conjunction with other metrics to make an investment decision.

When it comes to investing your money, it is important to do your due diligence. However, once you begin the research process, you’ll quickly discover that there are dozens of details to consider – from external factors like the economy and interest rates to internal factors like a company’s management and financial statements.

With so much to consider, deciding between two or more stocks can seem overwhelming. This is where financial metrics come into play.

“A financial metric is a valuation metric that scales a company’s financials and makes it easier for investors to compare themselves to other companies,” said Ryan Graves, CFA and president of Bemiston Asset Management.

We spoke to several financial experts to put together a list of the top financial metrics investors should know.

1. Price/Earnings to Growth

The price-to-earnings-to-growth, or PEG, ratio takes a company’s P/E ratio and divides it by the company’s earnings growth rate.

P/E is a popular metric for determining which stocks are over- and undervalued relative to others, but it has its weaknesses.

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“The key limitation of the price-to-earnings ratio is that it can’t capture earnings growth just by looking at how much someone is willing to pay per $1 of current earnings,” says Ryan Flanders, CFA and investment adviser at The Flanders Group. “Companies should grow over time,” says Flanders. “When deciding whether an investment is a value-for-money addition to a portfolio, it’s important to look not at relative value now, but over time.”

By using the PEG ratio, an investor can get a more accurate picture of a company’s relative worth. A PEG ratio below 1.0 can be an indicator that a stock is undervalued and a PEG ratio above 1.0 can be an indicator that a stock is overvalued.

2. Price to sales ratio

The price to sales ratio is calculated by dividing the company’s stock price by total sales. The price to sales ratio tells an investor what the market value of $1 of the company’s sales is.

“This can be a good ratio when a company is growing rapidly but isn’t turning a profit yet,” says Brian Feroldi, author of Why Does The Stock Market Go Up?. The ability to evaluate a stock before it has turned a profit is one of the reasons this ratio became popular in the 1990s before the dot-com bubble.

3. Gross Profit

Gross profit is perhaps one of the easiest financial metrics to find and calculate. “Net sales less cost of goods sold equals gross profit,” says Will Gogolak, finance professor at Carnegie Mellon University.

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Gross profit tells an investor whether a company is profitable. Gross profit does not take into account overhead, only the cost of directly producing goods. Overheads such as rent are calculated considering net profit.

“If you can’t make a gross profit, don’t expect a net profit,” says Gogolak. However, remember that gross profit is just a snapshot. Some companies may not have positive gross profit in the early years but later begin to become profitable.

4. Price cash flow

The Price to Cash Flow (P/CF) ratio compares a company’s stock price to its operating cash flow. Operating cash flow is the amount of money that the company makes from its normal operations. P/CF can be calculated by taking the company’s stock price and dividing it by the operating cash flow per share.

This ratio tells an investor how much money a company is making relative to its stock price. In general, a low P/E ratio indicates a company is undervalued, while higher ratios might indicate it is overvalued.

“The price-to-cash flow ratio is excellent because it’s less susceptible to management’s earnings manipulation than the popular price-to-earnings ratio,” says Graves. “Research also suggests that differences in price-to-cash flow ratios are related to differences in long-term average returns,” he adds.

The P/CF ratio is also important because positive cash flow can give a company the ability to navigate through challenges in an uncertain economic environment.

5. Free cash flow yield

Free cash flow is calculated by taking cash flow from operations minus capital expenditures and then dividing by the company’s market capitalization.

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Free cash flow yield is a measure of profitability that uses a company’s cash flow statement instead of the income statement. “It eliminates much of the noise that can obscure or amplify profitability on the income statement due to accounting decisions,” says David MacDougall, CFA and portfolio manager at Ipswich Investment Management.

“The higher the return on free cash flow, the more profitability there is after reinvesting in growth to reward shareholders with dividends, stock buybacks, or other investments for continued growth,” says MacDougall.

6. Return on invested capital

Return on Invested Capital (ROIC) is a measure of the profitability of a company’s investment decisions. It is calculated by dividing the net profit by the invested capital.

The ROIC ratio essentially asks, “Is the company’s reinvestment in the business generating a high enough return to cover debt payments and reward shareholders?” says MacDougall. “In general, a return on invested capital of over 10% is a good hurdle rate.”

The final result

Avoid the mistake of relying on just one metric to determine your entire portfolio. Financial metrics alone can only answer narrow questions and may omit information that could affect a stock’s performance, such as: B. pending lawsuits or changes in the industry.

“It’s important for investors to realize that every metric has flaws,” says Feroldi. “Relationships also need additional context.”

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