What these 3 key metrics tell you about a stock | personal finance

(Stefon Walters)

When analyzing a company, there are many metrics you can use to gain insight into its operations and financial health. If you look at a company’s financial statements, you can find everything from its profits to expenses to debt and much more. Here’s what these three metrics tell you about a stock.

1. Price-earnings ratio (P/E)

You shouldn’t look at a stock’s price alone to determine if it’s cheap or expensive; It could very well be the case that a $15 share is expensive and a $1,500 share is cheap. Investors should use metrics like price-earnings (P/E) ratio to determine if a stock is worth good value at its current price. The P/E ratio compares a company’s stock price to its earnings per share (EPS) and is one of the best ways to determine whether a company is overvalued or undervalued.

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When using the P/E ratio, it is important to compare companies within the same industry. Comparing Appleprice-earnings ratio of exxonmobile‘s, for example, would probably not return the best perspective. Instead, it would make more sense to compare Apple with Microsoft. As a general rule of thumb, if a company’s P/E ratio is significantly lower than other comparable companies, it is likely undervalued.

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2. Free cash flow

Although it appears similar to earnings, free cash flow is a different metric that typically measures how much money a business brings in after accounting for capital expenditures. For investors, a company’s free cash flow can give an idea of ​​its financial health, as well as its potential. The potential arises because free cash flow is what companies use for activities like paying dividends, paying down debt, buying back shares, or even making acquisitions.

With no free (or negative) cash flow, a business might have limited capital to use for these key activities. Free cash flow is particularly important for investors who want to invest in companies that pay dividends. If a company is paying more dividends than its free cash flow, that’s usually not a good sign. Strong free cash flow is a sign of a financially sound company.

3. Debt to equity ratio

You can find a company’s debt-to-equity ratio by dividing its total debt by its shareholders’ equity. This number lets you know how much of a company’s operations is financed through debt, and in general, the higher the ratio, the more risk the company takes. Some industries, by their nature, require more debt than others. That’s why it’s best to compare debt-to-equity ratios between companies within the same industry to get an idea of ​​which ones have problematic debt levels.

For companies that pay dividends, having a lot of debt increases the chances that they will have to cut their dividends during tough economic times. If a company goes into debt to maintain its dividends, that’s a red flag. Financially healthy companies should be able to pay dividends from their profits, not from taking on debt.

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Stefon Walters has positions at Apple and Microsoft. The Motley Fool has positions and recommends Apple and Microsoft. The Motley Fool recommends the following options: $120 long calls in March 2023 at Apple and $130 short calls in March 2023 at Apple. The Motley Fool has a disclosure policy.

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