Investing 101: Some Metrics

There are dozens of factors a person can consider when deciding where to put their investment funds. Because of this, and since this is supposed to be a quick overview, I’m obviously not going to cover them all. Instead, I thought I would simply look at the factors that I use to compare potential investment options when I am considering purchasing individuals shares.

I try to take a holistic look at any company that I am considering to spend money. It’s easy to run a screen and identify a population of companies to investigate further, but the numbers don’t tell the full story. As I mentioned yesterday, there are just some types of companies that I avoid because their business model may be hard to understand or it is too complicated to model future performance. Nevertheless, there are over 7,000 public companies in the market right now, so finding a way to shrink your population to a manageable number should help you find a diamond in the rough.

And these factors are not the only thing you should look at. Depending on your own personal philosophy, you might care about insider ownership or the short ratio of a stock before purchasing shares. You may not care about profitability in an attempt to find the next Amazon (Nasdaq: AMZN), or prefer not to invest in “sin stocks.” And that’s fine. I have invested in unprofitable companies before, and it worked out okay for me. However, my risk tolerance has shifted a bit and I prefer to find companies that are profitable (or at least fairly close to finally turning a profit).

With all that being said, here are some of the things that I use when looking for options to spend my investment dollars:

1) Market Capitalization – This is a minor factor when investing. Market capitalization – or market cap – is simply the current share price multiplied by the current shares outstanding. It fluctuates each day with the movement of the market, and is only the initial screening factor I use, if only because it helps me to identify companies of a certain size. I don’t really like to invest in companies with a market cap below $300 million if at all possible, so I can use that as a factor to eliminate companies from view. Using that factor alone cuts the population of companies by nearly 4,400 companies, indicating that there are a lot of small companies. Is the next big thing lurking among those 4,400 companies? It could be, but if I am looking on a regular basis, I may be able to find it when it crosses my $300M threshold.

2) Earnings Per Share – Generally, I want this number to be positive, and as big as possible. This number is calculated by dividing the trailing 12 months of earnings reported by the company by the latest shares outstanding. Companies report this number in their financial filings, which make their way to whatever financial website you may be using to screen companies. A negative earnings per share means that the company has lost money over the past year, and while not an immediate disqualifier, it would require me to take a look at other factors to determine if it is an investment to pursue. One of those factors is up next.

3) Price-to-Earnings Ratio (P/E) – This number is simply the current market price divided by the earnings, and is only calculated if earnings is positive. There are two versions of the P/E ratio that help illustrate how successful a company is or might be going forward. Basic P/E takes the current price and divides it by the earnings from the last 12 months. This shows where the company has been. When investing, however, it is more important to have an idea where the company might be going, which is why Forward P/E is a helpful metric. Instead of looking over the past 12 months, this ratio looks at the projected EPS over the next twelve months to see if the company looks like it is going to perform well going forward.

Generally, the lower the P/E the better, as stocks with high P/E ratios can be considered overpriced. The P/E ratio represents what investors are willing to pay for each dollar of earnings. P/E ratios also tend to differ from industry to industry, so it is not really a metric that should be used in a vacuum. Older, slower growing companies tend to have lower P/E ratios because investors aren’t expecting them to grow too fast, and are probably getting most of their return from dividends. However, stocks with three digit P/E ratios should not be immediately dismissed, as there might be a reason for their sky high valuations. For example, Amazon wasn’t profitable for a very long time, and didn’t have a profitable year until a few years back. If investor were only looking at P/E in the early days of Amazon, they would have missed out on a massively successful stock. Even now, Amazon’s P/E is over 300*, but they are one of the best at what they do. An investor should be willing to “pay up” for that potential, and hope that the earnings start to catch up to the actual share price over the long term.

*Amazon’s Forward P/E is currently 93, so it looks like the earnings are expected to more than triple over the next year (from $4.58 to $15.39).

4) Price-to-Book Ratio (P/B) – Book value is the value of an asset as it is carried on the balance sheet. The P/B ratio uses the share price divided by the book value per share to show investors how much an investor is spending on each dollar of book value. Book value can be considered as the value a company would fetch in liquidation. As with P/E, the lower the better, but it is even better if you can identify a company that is currently trading below its book value. In theory, if you have a P/B that is less than 1, the company is undervalued and you (theoretically) have upside at least up until its book value. Once the P/B ratio gets above 1, however, the stock could still have some room to grow, but you will be missing out on at least buying it at (or below) its liquidation value. Book value was the metric the Benjamin Graham, the man that taught Warren Buffett most everything he knows, would use to make his investing decisions.

5) Dividend Yield – Dividend yield only applies to companies that pay a dividend, a population of stocks that is just over 1,900 (still using the initial screen of market cap over $300M). Yield is simply the annual dividend divided by the current price. It can be viewed as a premium on the share price, as a dividend “locks in” some level of return on an investment. For example, if you buy $100 of some company with a 3% dividend, you can expect to get at least that 3% should the price fluctuate and sap your return from the price.

Most companies wait for a while to pay a dividend, so it usually marks a stable company that has been around for a while. However, it is not a pure discriminating factor, but instead a bonus if you find a company that tickles your fancy. Depending on the intent behind your investments, you may be looking to create the regular income that dividends provide. Or you may be simply juicing your returns by the “automatic” return given by dividends. Either way, it is something that I look at when I am screening companies ONLY IF I am looking for an income-producing stock. Otherwise, I would miss out on companies such as Amazon, Alphabet (Nasdaq: GOOG) (Google’s parent), Berkshire Hathaway (NYSE: BRK-B), and many other solid investments.

Again, this is not an end all, be all of the factors used to look at a stock. They are simply the ones that I use when trying to identify potential investments. For example, if I was looking for a mid-cap company that is profitable – both currently and in the future – but has a P/E less than 20 and a dividend yield of at least 2%, I could use a screener like FinViz and use it to identify 134 companies (as of 4/16). I can further screen based on P/B ratio, looking for companies with a P/B under 1.0 and identify 19 companies. That would be a smaller population than the 7,300+ in the market as a whole, and I would hopefully be able to identify at least a couple of options to do more research on. I’ll cover some of the things I look for while researching in my next post.

Until next time…

Disclosure: My mother owns shares of Amazon and Berkshire Hathaway in a portfolio I manage. Please see my full disclosure page for details.