What do these 3 key metrics tell you about the stock | Smart Change: Personal Finance
When analyzing a company, there are several metrics you can use to gain insight into its operations and financial health. If you take a look at a company’s financial statements, you can find everything from its earnings to expenses to debt and much more. Here’s what these three metrics tell you about the stock.
1. Price to Earnings Ratio (P/E)
You don’t have to look at the stock price alone to determine if it’s cheap or expensive; It may very well be that a $15 stock is expensive and a $1,500 stock is cheap. Investors should use metrics such as the price-to-earnings (P/E) ratio to determine if a stock is a good value at its current price. The P/E ratio compares a company’s stock price to its earnings per share (EPS), which is one of the best ways to determine if a business is overvalued or undervalued.
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When using the price-earnings ratio, it is important to compare companies in the same industry. Comparison appleP/E ratio to ExxonMobilFor example, it probably won’t provide the best view. Instead, it would make more sense to compare Apple to Microsoft. As a general rule, if a company’s P/E ratio is significantly lower than that of other similar companies, it is likely to be undervalued.
2. Free cash flow
Although it sounds similar to profit, free cash flow is a different metric that typically measures how much money a company makes after accounting for capital expenditures. For investors, a company’s free cash flow can give insight into its financial health as well as its potential. The potential comes because free cash flow is what companies use for activities such as paying dividends, paying off debt, repurchasing shares, or even making acquisitions.
With no free (or passive) cash flow, the company may have limited capital to use for these key activities. Free cash flow is especially important to know about investors who want to invest in companies that pay dividends. If a company is paying more dividends than free cash flow, that’s usually not a good sign. Strong free cash flow is a sign of a healthy financial company.
3. Debt to Equity Ratio
You can find a company’s debt-to-equity ratio by dividing its total debt by its equity. This number allows you to see how much a company’s operations are financed by debt, and generally, the higher the ratio, the more risk the company takes. Some industries, by their nature, require more debt than others. This is why it is best to compare debt-to-equity ratios between companies in the same industry to identify those with problematic debt levels.
For dividend-paying companies, having a lot of debt increases the chances that they will have to cut their dividends during tough economic times. If a company takes on debt to maintain its dividend, that’s a red flag. Financially healthy companies should be able to pay their dividends from their earnings, not from borrowing.
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Stefon Walters holds positions at Apple and Microsoft. Motley Fool has and recommends positions at Apple and Microsoft. Motley Fool recommends the following options: long March 2023 calls worth $120 on Apple and short March 2023 calls worth $130 on Apple. Motley Fool has a disclosure policy.