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5 Metrics to Know If a Stock Is Right for You

by FlexInvest about a month ago in investing

It’s easy to get overwhelmed with so many formulas and methods, so we’ve compiled the most common valuation methods for you.

Before we start, you should know that none of the following metrics are useful as a single method of valuation; you may need to combine all of them to get a broader and better view of a stock’s worth.

You may also find it useful to compare them to competitors and to the market (indexes) to see how that particular industry and the economy overall are doing.

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Now, about those metrics…

1. P/E ratio

This measure of a stock’s value tells you how much investors are willing to pay to receive $1 of the company’s current earnings. It’s calculated by dividing a company’s current stock price by its earnings per share.

In general, a high P/E suggests that investors are expecting higher growth in the future. A low P/E might indicate that a company is currently undervalued or that its earnings are expected to remain stable.

This mispricing prompts investors to buy the stock before the market corrects it. And when it does, investors make a profit as a result of a higher stock price.

To determine if a P/E ratio is too high or too low, investors compare it to the P/E ratio of its peer stocks and of the industry. It’s also useful to compare it to the historical P/E ratio of the stock. If there is a major difference when measuring stocks against other factors (peer stocks, its past P/E ratio, industry, and even the market as a whole), you should always investigate why.

Now, you’re probably wondering how to work out the earnings per share to work out the P/E ratio. We’re one step ahead!

2. Earnings per share (EPS)

This metric shows if a company is profitable for common shareholders. It’s calculated by taking the net income and dividing it by its number of common shares outstanding (in company’s financial statements, which can be found online).

It’s a useful measure when comparing two companies in the same industry, with the same number of shares outstanding. Oh, and yes, a higher EPS means better profitability.

However, keep in mind that this measure doesn’t tell you how — or how efficiently — the company spends its capital. Some companies take those earnings and reinvest them in the business. Others pay them out to shareholders in the form of dividends.

Quick reminder: Dividends are sums of money paid by a company to its shareholders out of its profits.

3. Price-to-earnings-to-growth (PEG) ratio

This measures the relationship between the P/E ratio and earnings growth. Let’s break it down...

The benchmark for the PEG ratio is 1. Stocks with a PEG under 1 are considered undervalued, since its price is low compared to the company's expected earnings growth.

On the other hand, those with a PEG greater than 1 are considered overvalued since it might mean that investors are paying a higher share price today because they expect high growth in the future (this is the case with most technology stocks.)

4. Dividend yield

It’s a percentage calculated by dividing the stock's annual dividend by the stock's price.

As with all valuation ratios, dividend yield must be used with caution. Stocks with very high dividend yields might seem like you’re getting a great deal, but these companies are often going through financial problems that have caused their stock price to plunge. It's not unusual for companies in such situations to cut their dividend in order to save cash.

Additionally, the dividend yield is useless for companies that don't pay a dividend - a group that includes many technology stocks, for instance.

5. Payout ratio

The dividend payout ratio is a percentage that shows much a company is paying out from their earnings to shareholders as a dividend.

Remember! There is no such thing as the perfect payout ratio, it really depends on the industry and on how the company is using its earnings.

For example, a higher payout ratio might reflect either poor management (a company is paying more than it’s earning) or that it’s an established company that is not reinvesting its earnings in order to grow further.

Phew, that’s a lot to take in, right?

Well, we recommend focusing on two just to get the hang of valuing stocks. Then when you feel confident, you can learn them all (that’s if you have nothing better to do!).

Warren Buffet says that you should invest in companies you understand, and if you can’t understand a company in 10 minutes you should move on to evaluate another.

So remember, invest in companies that you trust and understand to make investing enjoyable and easier.

Before you go out to start your investing journey, make sure to explore the articles on the FlexAcademy blog to discover more interesting investing tips.

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