Black2)Top 10 Financial Metrics for Evaluating Stocks

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In this Video, We Will Talk About the Top 10 Financial Metrics for Evaluating Stocks

1: Dividend Payout Ratio

The dividend payout ratio is one of the most common financial ratios known by income investors. The payout ratio measures how much of a company’s earnings are paid out as a dividend.

To calculate a company’s dividend payout ratio, simply divide the number of dividends it paid over a certain time period by the number of earnings it generated. 

For example, if Coca-Cola paid $6 per share in dividends while generating $10 per share in earnings, it would have a payout ratio of 60% ($6 / $10 = 60%).

Investors like to analyze the dividend payout ratio because it can inform how safe a company’s dividend is and how much room it has for future growth.

A high payout ratio (e.g. above 80%) could mean that the dividend payment is riskier because it consumes the majority of a company’s earnings. If business trends unexpectedly fall, there might not be enough profits to keep paying the dividend. 

2: Free Cash Flow

Without free cash flow, a company is unlikely to survive over the long run. 

Free cash flow is calculated using the company’s statement of cash flows. A company’s capital expenditures (i.e. money spent on property, plant, and equipment) are subtracted from its cash flow from operations (i.e. net income adjusted for non-cash charges such as depreciation) to arrive at free cash flow.

If a company does not generate free cash flow, it does not have funds to return to shareholders via dividends and share repurchases, nor does it have sustainable cash flow to use for acquisitions or debt repayments. 

Companies that fail to generate free cash flow typically have capital-intensive businesses with few competitive advantages. We prefer to invest in companies that consistently generate free cash flow in most environments.

3: Return on Invested Capital

Suppose you had $100 to invest. One company can turn your $100 into $105, but another company can produce $110 with your money. All other things equal, we would pick the second company because it can grow our money faster.

To keep things simple, that is what return on invested capital is all about. Businesses take in funds (debt and/or equity) and invest to generate a return for shareholders. 

Companies that earn higher returns can compound our capital faster and are generally more desirable. Companies that earn returns below what investors demand should, in theory, eventually go out of existence.

For these reasons, one of Warren Buffett’s favorite financial ratios is the return on equity, which divides a company’s net income by its shareholders’ equity. 

For example, if shareholders bought $100 of stock to fund a company and it generated $10 of profit, the company’s return on equity would be 10% ($10 of net income divided by $100 of equity). 

4: Operating Margin

A company’s operating profit margin divides its operating profits by its total sales. Operating profits generally represent the company’s earnings before interest and taxes.

By excluding these expenses, we can compare companies regardless of their financing choices (debt results in interest expenses) and tax treatments to focus on the profitability of their actual operations. Higher operating profit margins can be a sign that a company has an economic moat.

Just like with our analysis of a company’s return on invested capital, we pay close attention to the level and consistency of a company’s operating margin. High and stable margins are preferable because they help earnings compound faster.

5: Sales Growth

Sales growth compares the change in revenue between two periods and is expressed as a percentage. For example, if sales increased from $100 in 2022 to $120 in 2023, sales growth would be 20% ([$120 – $100] / $100).

Trends in sales growth can inform us about the volatility of a company’s business model and its ability to continue expanding.

Let’s take a look at Caterpillar as an example. As seen below, the heavy equipment maker's sales have plunged by double-digits multiple times over the past decade. When the economy slows, demand for big-ticket machinery falls fast.

6: Net Debt to Capital

Financial leverage can be dangerous:

A company's net debt to capital ratio reveals how much debt (net of cash on hand) a firm is using to run its business.

If a company has $100 worth of equipment, it acquired that equipment through some combination of debt and equity.

The net debt to capital ratio tells you what proportion of a company’s financing is from debt. Using the example above, suppose the $100 of equipment was supported by $20 of debt and $80 of equity.

The company’s debt-to-capital ratio would be calculated as follows: total book debt ($20) divided by total book debt ($20) plus equity ($80). The result is a debt-to-capital ratio of 20% ($20 / $100). In other words, debt accounts for 20% of the company’s capital structure.

7: Net Debt to EBITDA

While the debt-to-capital ratio focuses on a company’s capital structure, the net debt-to-EBITDA ratio compares a company’s debt to its earnings.

The idea behind this financial ratio is that a company with a seemingly high level of debt might not be as risky as it appears if it is generating a lot of profits and has plenty of cash on hand.

Net debt is a company’s total debt less the cash it has on hand. For example, if a company had $100 of debt and $10 of cash, its net debt would be $90.

8: Price-to-Earnings Ratio

The price-to-earnings (P/E) ratio is arguably the most popular valuation metric used by investors.

The metric divides a company’s stock price by the amount of earnings per share it has generated over a one-year period.

Historically speaking, the average P/E multiple for the market has been about 15. Stocks perceived to have more stable earnings and faster earnings growth potential usually trade at higher earnings multiples than the market.

For mature companies with stable long-term outlooks, we like to compare their current P/E ratios with their long-term averages. This can reduce the risk of overpaying if you avoid buying shares when the stock's multiple trades well above its typical range.

9: Shares Outstanding

Companies that need a lot of cash issue shares (and/or debt). Companies that generate more cash than they know what to do with can buy back their shares (and/or pay dividends).

The long-term trend in shares outstanding can tell you which type of company you are dealing with. Here's a look at Apple's impressive chart:

We generally like businesses that reduce their shares outstanding over time. This increases our ownership stake without requiring us to put in more capital. And it happens tax-free.

10: Timeliness

Since 1970, dividends have made up 40% of total returns for stocks in the U.S. and Europe, per data from JPMorgan cited by The Wall Street Journal. (Total return measures capital gains, plus dividends received.)

Given the importance of dividends to a portfolio’s returns, evaluating a stock’s historical dividend yield range can help gauge whether or not a stock’s current price appears reasonable.

If a company's dividend remains safe and its long-term outlook appears unchanged, snapping up shares when they trade at a relatively high yield can be an attractive proposition.

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