Investing in Stocks— Top financial metrics to consider
Dividend investing is a strategy that involves buying stocks in companies that pay dividends and holding onto those stocks for the long term in order to receive a steady stream of income from the dividends. The goal of dividend investing is to build a portfolio of dividend-paying stocks that can provide a reliable source of income over time. To be successful at dividend investing, it is important to do thorough research on the companies you are considering investing in, as well as to diversify your portfolio in order to minimize risk.
There are several financial ratios that can be helpful to consider when evaluating a company’s dividend-paying potential. Here are a few ratios that you might want to look at:
1. Dividend Payout Ratio:
The dividend payout ratio is the percentage of a company’s earnings that are paid out as dividends to shareholders. It is important to consider the dividend payout ratio when evaluating a company as a potential investment because it can give you an idea of how sustainable the company’s dividends are.
A high dividend payout ratio may indicate that the company is paying out a large portion of its earnings as dividends, which could be a red flag if the company does not have enough earnings to cover its dividend payments. This could be a sign that the company’s dividends are not sustainable in the long term, and the company may have to cut its dividends or stop paying them altogether if its earnings decline.
On the other hand, a low dividend payout ratio may indicate that the company has a lot of room to increase its dividends in the future, or that it is reinvesting a significant portion of its earnings back into the business in order to fuel growth. For example, Cisco pays $1.52 annual dividends per share, and forward annual earnings are $3.4. So payout ratio is 44.7%.
I consider payout ratios less than 80% to be a good company but less space to increase dividends in the future and below 50% is the best. These companies have a better chance to increase dividends in the future. More than 100% is a red flag for me as a dividend cut is a strong possibility.
2. Price-to-Earnings (PE) Ratio:
The price-to-earnings (P/E) ratio is a financial ratio that compares a company’s stock price to its earnings per share (EPS). It can be an important factor to consider when evaluating a company as a potential dividend investment because it gives you an idea of how much you are paying for each dollar of earnings.
A high P/E ratio may indicate that the market is willing to pay a premium for the company’s earnings, which could be a sign of strong growth prospects. However, it could also be a sign that the stock is overvalued, and that the company’s future earnings may not justify the current price.
On the other hand, a low P/E ratio may indicate that the stock is undervalued and that it has the potential for price appreciation in the future. However, it could also be a sign that the market is not confident in the company’s growth prospects or is experiencing financial difficulties.
3. Free Cash Flow (FCF) / Operating Cash Flow (OCF) per share:
Free cash flow is important in investing because it represents the amount of cash a company has available for reinvestment or distribution to shareholders after accounting for capital expenditures. It is a measure of a company’s financial performance and its ability to generate cash. Investors use free cash flow as a key indicator of a company’s health and stability, as it provides insight into its ability to pay dividends, reduce debt, and fund future growth initiatives. A positive free cash flow is generally seen as a positive sign for investors, while a negative free cash flow may indicate financial difficulties and a higher risk of future financial problems.
To understand a company’s free cash flow in investing, follow these steps:
- Review the company’s cash flow statement: The cash flow statement provides information on a company’s inflows and outflows of cash, including operating activities, investing activities, and financing activities.
- Calculate free cash flow: Free cash flow is calculated by subtracting capital expenditures from the net cash generated from operating activities. It represents the amount of cash available for reinvestment or distribution to shareholders.
- Compare free cash flow to operating cash flow: Operating cash flow is the amount of cash generated by a company’s day-to-day operations, while free cash flow takes into account capital expenditures. If free cash flow is lower than operating cash flow, it may indicate that a company is investing heavily in growth initiatives.
- Compare free cash flow to net income: Net income is the profit a company generates, while free cash flow is the amount of cash available after accounting for capital expenditures. If free cash flow is lower than net income, it may indicate that a company is financing growth through borrowing or other means.
- Look at trends over time: Free cash flow can fluctuate, so it’s important to look at trends over time to see if a company is consistently generating positive free cash flow or if there are periods of negative cash flow.
- Consider the company’s overall financial picture: Free cash flow shouldbe considered in the context of a company’s overall financial picture, including its debt levels, investment opportunities, and overall business performance. A company with a strong free cash flow but high debt levels may still be seen as a higher-risk investment compared to a company with a lower free cash flow but low debt levels.
In summary, understanding a company’s free cash flow requires a comprehensive analysis of its financial statements, considering trends over time, and comparing it to other financial metrics. This information can help investors assess a company’s financial health and its ability to generate cash, which is important for making informed investment decisions.
Operating cash flow is a measure of a company’s ability to generate cash from its day-to-day operations. It represents the amount of cash generated from a company’s core business activities, such as sales, production, and the delivery of goods and services. Operating cash flow is calculated by subtracting operating expenses from operating revenues, and it represents the cash that a company has available to pay debts, reinvest in the business, or distribute to shareholders as dividends.
Investors use operating cash flow as a measure of a company’s financial stability and as a key indicator of its ability to generate positive cash flow. A company with strong operating cash flow is generally seen as a more attractive investment because it has the financial strength to fund its operations, pay debts, and invest in growth initiatives. On the other hand, a company with weak or negative operating cash flow may face financial difficulties and be seen as a higher-risk investment.
Free cash flow and operating cash flow are two important financial metrics used to evaluate a company’s financial performance and stability. While they are related, there are some key differences between the two:
- Definition: Operating cash flow measures the amount of cash generated from a company’s core business activities, while free cash flow measures the amount of cash available for reinvestment or distribution to shareholders after accounting for capital expenditures.
- Calculation: Operating cash flow is calculated by subtracting operating expenses from operating revenues, while free cash flow is calculated by subtracting capital expenditures from the net cash generated from operating activities.
- Purpose: The purpose of operating cash flow is to provide insight into a company’s ability to generate cash from its day-to-day operations, while the purpose of free cash flow is to give investors an understanding of a company’s financial strength and stability after accounting for capital expenditures.
- Interpretation: A company with strong operating cash flow is generally seen as financially stable, while a company with positive free cash flow is seen as having the ability to reinvest in growth initiatives or distribute to shareholders. Negative operating cash flow may indicate financial difficulties, while negative free cash flow may indicate a higher risk of financial problems in the future.
In conclusion, while both free cash flow and operating cash flow are important financial metrics, they provide different information and should be used together to gain a comprehensive understanding of a company’s financial performance and stability.
4. Return on Invested Capital (ROIC):
Return on Invested Capital (ROIC) is a financial metric that measures the efficiency and profitability of a company’s investments. It indicates how much profit a company has generated per unit of capital it has invested. ROIC is a useful measure to evaluate a company’s ability to create value for its shareholders.
To calculate ROIC, you can use the following formula:
- NOPAT is the company’s operating profit after taxes. It is calculated by subtracting operating expenses and taxes from operating revenues.
- Invested Capital is the total amount of capital invested in the company. It includes all long-term debt, preferred stock, and equity.
Once you have calculated the ROIC, you can compare it to the company’s cost of capital. If the ROIC is higher than the cost of capital, it indicates that the company is generating value for its shareholders.
A high ROIC indicates that the company is efficiently using its capital to generate profits, while a low ROIC suggests that the company is not making efficient use of its capital. In general, companies with high ROIC are more attractive to investors because they are generating more profits per dollar of investment. However, it’s important to keep in mind that ROIC varies widely across different industries, and it’s often more useful to compare a company’s ROIC to its peers in the same industry to get a better sense of its performance.
The importance of considering the ROIC of a company than ROI is ROIC accounts for a company’s debt in the calculation which is very important to know for investors.
5. Operating Profit Margin (OPM):
Operating profit margin (OPM) is a financial metric used to evaluate a company’s profitability by measuring the percentage of revenue that remains after deducting operating expenses, such as wages, rent, and supplies. It is calculated by dividing a company’s operating income (also known as EBIT, or earnings before interest and taxes) by its revenue, and multiplying the result by 100 to get a percentage.
The formula for calculating the operating profit margin is:
This means that for every dollar of revenue, Apple Inc. is generating 29.4 cents of operating profit while General Motors is generating only 6.58 cents of operating profit. A higher OPM indicates that the company is operating more efficiently and generating more profit from its operations, while a lower OPM may indicate that the company is experiencing higher operating expenses or lower sales.
However, the OPM may vary depending on the industry, business model, and other factors. However, generally speaking, a higher OPM is generally considered better as it indicates that a company is generating more profit from its operations.
In some industries, such as technology, a high OPM is common, while in others, such as retail, a lower OPM may be typical. Additionally, a company’s OPM may fluctuate over time due to various factors, such as changes in market conditions, competition, or business strategy.
Therefore, it is important to consider the context and compare a company’s OPM to its competitors and industry benchmarks when evaluating its performance. It is also important to note that a high OPM alone does not necessarily indicate long-term success or sustainability, as other factors, such as revenue growth, customer acquisition, and innovation, are also crucial for a company’s success.
6. Asset Turnover:
Asset turnover is a financial ratio that measures a company’s efficiency in using its assets to generate revenue. It is calculated by dividing a company’s revenue by its total assets.
The formula for calculating asset turnover is:
This means that for every dollar of assets, Apple Inc. generates $1.12 of revenue while general motors generate $0.59 of revenue
A high asset turnover ratio can indicate that a company is effectively utilizing its assets to generate revenue, which may be a positive sign for investors. However, a high asset turnover ratio alone does not necessarily indicate a profitable company, as other financial metrics, such as net income or cash flow, must also be considered.
It is also important to note that the ideal asset turnover ratio can vary depending on the industry, as some industries require higher levels of assets to generate revenue than others. For example, companies in the retail industry typically have a higher asset turnover ratio than those in the manufacturing industry because they have lower levels of fixed assets and inventory turnover is higher. A low asset turnover ratio may indicate that a company is not using its assets effectively to generate revenue, which can result in reduced profitability and return on investment. Therefore, it is important to compare a company’s asset turnover ratio to its peers within the same industry to gain a better understanding of its performance.
7. Sales Growth:
Sales growth refers to the percentage increase or decrease in a company’s revenue over a period of time, usually a year. It measures how much a company’s sales have grown or declined compared to the previous year or a designated time period.
Sales growth can be calculated using the following formula:
Sales Growth = (Current Year’s Sales — Previous Year’s Sales) / Previous Year’s Sales x 100%
For example, if a company had sales of $1,000,000 in the previous year and sales of $1,200,000 in the current year, the sales growth would be:
Sales Growth = ($1,200,000 — $1,000,000) / $1,000,000 x 100% = 20%
This means that the company’s sales increased by 20% from the previous year.
Sales growth is an important metric for investors and analysts to evaluate a company’s financial health and potential for future growth. A high sales growth rate indicates that the company is generating increasing revenue, which may be a sign of a healthy and growing business. However, it is important to consider other financial metrics such as profit margins, return on investment, and cash flow, to gain a comprehensive understanding of a company’s financial performance.
8. Net Debt-to-capital ratio:
Net debt-to-capital is a financial ratio that measures the proportion of a company’s capital structure that is comprised of debt, after accounting for cash and cash equivalents. It is calculated by dividing a company’s net debt (total debt minus cash and cash equivalents) by its total capital (net debt plus equity).
The formula for calculating net debt-to-capital is:
Net Debt-to-Capital = Net Debt / (Net Debt + Equity)
For example, if a company has net debt of $500,000 and total equity of $1,500,000, its net debt-to-capital ratio would be:
Net Debt-to-Capital = $500,000 / ($500,000 + $1,500,000) = 25%
This means that 25% of the company’s capital structure is comprised of net debt, after accounting for cash and cash equivalents.
Net debt-to-capital is an important metric for investors and analysts to evaluate a company’s financial risk and leverage. A high net debt-to-capital ratio indicates that a company is relying more on debt financing and may have higher financial risk, while a low ratio suggests that the company has a stronger financial position with more equity financing.
It is important to note that the ideal net debt-to-capital ratio can vary depending on the industry, business model, and other factors. Therefore, it is important to compare a company’s net debt-to-capital ratio to those of its peers within the same industry and consider other financial metrics to gain a comprehensive understanding of its financial health.
9. Net Debt / EBITDA:
Net debt/EBITDA is a financial ratio that measures a company’s ability to pay off its debt based on its earnings before interest, taxes, depreciation, and amortization (EBITDA). It is calculated by dividing a company’s net debt (total debt minus cash and cash equivalents) by its EBITDA.
The formula for calculating net debt/EBITDA is:
Net Debt/EBITDA = Net Debt / EBITDA
For example, if a company has net debt of $1,000,000 and EBITDA of $500,000, its net debt/EBITDA ratio would be:
Net Debt/EBITDA = $1,000,000 / $500,000 = 2
This means that it would take the company two years of EBITDA to pay off its net debt.
Net debt/EBITDA is an important metric for investors and analysts to evaluate a company’s financial leverage and debt repayment capacity. A high net debt/EBITDA ratio indicates that a company has a higher level of debt relative to its EBITDA, which may be a sign of higher financial risk. On the other hand, a low net debt/EBITDA ratio indicates that the company has a lower level of debt relative to its EBITDA and may have a stronger financial position.
It is important to note that the ideal net debt/EBITDA ratio can vary depending on the industry, business model, and other factors. Therefore, it is important to compare a company’s net debt/EBITDA ratio to those of its peers within the same industry and consider other financial metrics to gain a comprehensive understanding of its financial health.
10. Total Shareholder Return:
Total shareholder return (TSR) is a financial metric that measures the total return that an investor earns on their investment in a company’s stock, including both capital appreciation and dividends received over a period of time. It is often used by investors to evaluate the performance of a company’s stock and compare it to the returns of other investment options.
TSR can be calculated using the following formula:
TSR = (Ending Share Price — Beginning Share Price + Dividends) / Beginning Share Price x 100%
For example, if a company’s stock price was $50 at the beginning of the year and $60 at the end of the year, and it paid $2 in dividends during the year, the TSR would be:
TSR = ($60 — $50 + $2) / $50 x 100% = 24%
This means that the investor earned a total return of 24% on their investment in the company’s stock over the year.
TSR is an important metric for investors to evaluate the performance of a company’s stock over a period of time. A high TSR indicates that the company has generated strong returns for its shareholders, while a low or negative TSR may indicate poor performance. However, it is important to consider other factors such as the company’s financial health, market conditions, and future growth prospects before making investment decisions based solely on TSR.
11. Price-to-Earnings growth Ration:
The price-to-earnings growth ratio (PEG ratio) is a financial metric that is used to evaluate the valuation of a stock by considering its earnings growth rate. It is calculated by dividing the stock’s price-to-earnings (P/E) ratio by its earnings per share (EPS) growth rate.
The formula for calculating the PEG ratio is:
PEG Ratio = P/E Ratio / EPS Growth Rate
For example, if a company has a P/E ratio of 20 and an EPS growth rate of 10%, its PEG ratio would be:
PEG Ratio = 20 / 10 = 2
A PEG ratio of 1 indicates that the stock is fairly valued based on its earnings growth rate, while a PEG ratio less than 1 may indicate that the stock is undervalued, and a PEG ratio greater than 1 may indicate that the stock is overvalued.
The PEG ratio is a useful tool for investors to compare the relative value of different stocks within the same industry or sector. However, it is important to use the PEG ratio in conjunction with other financial metrics and analysis to make informed investment decisions. Additionally, the PEG ratio should not be used as the sole determinant of a stock’s valuation.
12. Price to Sales Ratio (P/S):
The price-to-sales (P/S) ratio is a financial metric used to evaluate the valuation of a company’s stock by comparing its current stock price to its revenue per share. The P/S ratio is calculated by dividing a company’s market capitalization by its total revenue.
The formula for calculating the P/S ratio is:
P/S Ratio = Market Capitalization / Total Revenue
For example, if a company has a market capitalization of $1 billion and total revenue of $500 million, its P/S ratio would be:
P/S Ratio = $1 billion / $500 million = 2
This means that investors are willing to pay $2 for every $1 of the company’s revenue.
The P/S ratio is useful for comparing the valuations of companies within the same industry or sector, as it provides a measure of how much investors are willing to pay for each dollar of a company’s sales. However, it is important to use the P/S ratio in conjunction with other financial metrics and analysis, as a low P/S ratio does not necessarily indicate a good investment opportunity. Additionally, the P/S ratio may be less useful for companies that have not yet generated significant revenue or that have highly variable revenue streams.
The “better” P/S ratio for a stock depends on various factors, such as the industry, market conditions, and growth prospects of the company. Generally, a lower P/S ratio may indicate that a stock is undervalued, while a higher P/S ratio may indicate that it is overvalued. However, this can vary widely between different industries and sectors.
13. Price-to-Book Ratio (P/B ratio):
The price-to-book ratio (P/B ratio) is a financial metric used to evaluate the valuation of a company’s stock by comparing its current market price to its book value per share. The book value per share is calculated by dividing a company’s total assets minus its total liabilities by the number of outstanding shares.
The formula for calculating the P/B ratio is:
P/B Ratio = Market Price per Share / Book Value per Share
For example, if a company has a market price per share of $50 and a book value per share of $25, its P/B ratio would be:
P/B Ratio = $50 / $25 = 2
This means that investors are willing to pay $2 for every $1 of the company’s book value per share.
The P/B ratio is useful for comparing the valuations of companies within the same industry or sector, as it provides a measure of how much investors are willing to pay for each dollar of a company’s assets. However, like other financial metrics, it should be used in conjunction with other factors and analyses when making investment decisions. Additionally, the P/B ratio may be less useful for companies with significant intangible assets, such as patents or trademarks, that are not reflected in their book value.
A low price-to-book (P/B) ratio is not necessarily an indicator that a stock is good or bad, as the P/B ratio should be used in conjunction with other financial metrics and analysis when evaluating a company’s valuation and potential for investment.
However, a low P/B ratio may suggest that a stock is undervalued relative to its book value. A low P/B ratio may also indicate that the market is not recognizing the company’s true worth, which may present an opportunity for investors to purchase the stock at a discount.
14. Price to Free Cash Flow (P/FCF):
The P/FCF ratio is a financial metric used to evaluate the valuation of a company’s stock by comparing its current market price to its free cash flow per share. Free cash flow is the cash generated by a company after accounting for capital expenditures and other investments.
The formula for calculating the P/FCF ratio is:
P/FCF Ratio = Market Price per Share / Free Cash Flow per Share
For example, if a company has a market price per share of $50 and a free cash flow per share of $5, its P/FCF ratio would be:
P/FCF Ratio = $50 / $5 = 10
This means that investors are willing to pay $10 for every $1 of the company’s free cash flow per share.
The P/FCF ratio is a useful financial metric for evaluating the valuation of a company’s stock because it considers the company’s cash-generating ability rather than just its earnings. A lower P/FCF ratio may suggest that a company is undervalued relative to its free cash flow, while a higher P/FCF ratio may suggest that it is overvalued.