The Metrics – II
In this second module of the Stock Market Course by TPIN, we will be analysing the different metrics that can be used to help with your decision to buy or sell a stock. The goal in the Stock Market is to always buy low and sell high. One buys low by always understanding the real value of a specific stock. These metrics are important to help you understand if the investment you are making is correctly valued, overvalued or undervalued. The metrics that we will review in this module are:
Free Cash Flow
Earnings Per Share
Analysts Analysis and Expected Growth
Price-to-Earnings Ratio (P/E Ratio)
Starting with the P/E Ratio, one of the most used metrics to value a stock, it represents what the market is willing to pay for a stock based on its past and future earnings. So, a lower P/E Ratio would mean that investors are willing to pay a lower amount for each dollar in return. Essentially, it can flag an undervalued company. The contrary happens with a higher P/E Ratio. A higher P/E shows that you are paying more for each dollar that the company earns, therefore, that company may be overvalued.
The formula that is used to find the P/E Ratio is to divide the Stock Price with the Earnings Per Share (EPS) of the company.
Price-to-Book Ratio (P/B Ratio)
One of the most important things is to understand if a company has more assets then liabilities. This is the metric that analysis that exact problem. Say you want to invest in a specific company whose book value is $1,000,000, 100,000 outstanding shares and a $20 price per share. To calculate the book value, you start by dividing the $1,000,000 with the 100,000 shares, that gives you the book value per share of $10. You then divide the stock price of $20 with the $10 book value, that will give you your P/B Ratio of 2. That means that if the company was to be sold today and was to sell all their assets, what you are paying for the stock is twice what you would get if the company sold all their assets. That means that this company is overvalued. An attractive P/B Ratio would be 0.5.
Debt-to-Equity Ratio (D/E)
One of the main parts of buying a share, that can absolutely that can absolutely be a deal-breaker, is the amount of debt a company has. Companies, usually, accrue debt to purchase assets that might give them a long-term advantage, and those assets may even pay for themselves. This ratio shows the proportion of equity to debt a company is using to finance its assets. A low debt-to-equity ratio means the company uses a lower amount of debt for financing versus shareholder equity. A high debt-equity ratio means the company derives more of its financing from debt relative to equity. Too much debt can pose a risk to a company if they don't have the earnings or cash flow to meet its debt obligations.
Free Cash Flow (FCF)
There are three main financial statements you should always care to check out before buying a stock, and while you have it: the Income Statement, the Balance Sheet and the Cash Flow. I will go deeper with this in the next module. However, you can find the Free Cash Flow in the Cash Flow statement. The FCF show the investor how much cash will be left over after a company pays for its remaining operating expenses and capital expenditures. Free Cash Flow shows how efficient a company is at generating cash and is an important metric in determining whether a company has sufficient cash, after funding operations and capital expenditures, to reward shareholders through dividends and share buybacks.
PEG Ratio stands for Price/Earnings-to-Growth Ratio and it is a modified version of the normal P/E Ratio. The P/E Ratio does not take into account the earnings growth, but the PEG Ratio does. The PEG ratio measures the relationship between the price/earnings ratio and earnings growth. The PEG ratio provides a more complete picture of whether a stock's price is overvalued or undervalued by analysing both today's earnings and the expected growth rate. A PEG Ratio that has fewer than 1 means that a company is undervalued, as opposed to the PEG Ratio higher than 1, which shows that a company is overvalued.
Beta is a measurement of how reactive a stock is, compared to the overall market, generally defined as the S&P 500. A beta of 1 indicates that a stock tends to move in line with the S&P 500 -- that is, a 5% upward trajectory within the index should produce roughly the same movement in the stock.
A beta of less than 1 indicates that a stock is less reactive to market swings, while a beta of more than 1 indicates a more volatile stock. For example, if a stock's beta is 0.4, a 10% move in the S&P 500 should theoretically produce a 4% swing in the stock. Similarly, a negative beta indicates that a stock tends to move in the opposite direction of the market.
EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, show you, the investor, a measure of profitability. The earnings, tax, and interest figures are found on the Income Statement, as you will see in the third module, while the depreciation and amortization figures are normally found in the notes to operating profit or on the cash flow statement. The usual shortcut to calculate EBITDA is to start with operating profit, also called earnings before interest and tax (EBIT) and then add back depreciation, a reduction in the value of an asset over time, due in particular to wear and tear, and amortization, accounting technique used to periodically lower the book value of a loan or intangible asset over a set period of time. Using this metric you understand if a company is profitable or not.
The Formula for the calculation of the EBITDA is the sum of the Net Income with Interest, Taxes, Depreciation and Amortization.
The Market Capitalization, or Market Cap., is the total dollar market value of a company’s outstanding shares. Its calculous is quite simple, it is the multiplication of the total of outstanding shares with their market price. So, if one company´s share price is $20 and their number of outstanding shares is 100,000, then their market cap would be $2,000,000. It determines how much the stock market values a specific company. It is often more important to see a company’s market cap and evaluate that rather than to do so with their price per share. If a company’s price per share is $1000, that might sound expensive at first, because the dollar amount is relatively high. But, if that company’s market cap is $100,000, it means that you will have a big part of the company.
Earnings per Share (EPS)
Earnings per share (EPS) is calculated as a company's profit divided by the outstanding shares of its common stock. The resulting number serves as an indicator of a company's profitability. It is common for a company to report EPS that is adjusted for extraordinary items and potential share dilution. The higher a company's EPS, the more profitable it is considered. A good example would be to compare two companies, Company A and Company B. Company A reported a profit of $1,000,000, a dividend of $200,000 and it has 100,000 outstanding shares, therefore, Company’s A EPS is $8 ((1,000,000-200,000) / 100,000). Company B has reported a profit of $2,000,000, a dividend of $200,000 and it has 300,000 outstanding shares, therefore, Company’s B EPS is $6 ((1,000,000-200,000) / 300,000). So, even though company A has reported a smaller profit, it has a higher EPS. This is a good metric to help you decide between companies to invest in. It is even better used when the two companies are from the same industry.
The final point in this module is to take care of the Analysis and predictions that are made by the Analysts. Wall Street really cares about their analysts and it can drive a price up or down with ease. It will also show you what the future prediction for a stock is. If, for example, a stock has had a bad year, but is predicted to rise substantially, this metric will predict the stock’s rise. Therefore, it is an important metric to take into account.
To conclude this second module of our Stock Market Course, it has to be taken into account that no metric is the perfect one that will tell you with certainty that a stock is a buy or a sell. Rather, it is a combination of multiple metrics that go beyond what was explained in this module. We will be covering additional metrics further in the course but the information that was given today is a lot, and will take you some practice to fully comprehend.