5 Key metrics every investor should know
Invest smarter with these key metrics.
Updated 
6 min. read
Buying and selling stocks on your own can be financially rewarding, cost-effective and fun, but the do-it-yourself approach also takes dedication. Picking stocks involves research, number crunching and ensuring the companies you’re considering will provide value in the long run. To do this right you’ll need to know what to look for – and understand some investing jargon.
Investment professionals use a variety of metrics to determine whether companies are cheap or expensive or if they’re carrying a lot of debt. It’s a good idea for stock-picking investors to familiarize themselves with these metrics and ratios.
Here are five metrics to get you started.
1. Price-to-earnings (P/E) ratio
The vast majority of investors favour this metric because it helps indicate how much someone is willing to pay for every dollar of earnings a company generates. It’s calculated by dividing a business’s current price per share by its earnings per share.
It’s an easy way for investors to see if a stock is under or overpriced. If a stock has a P/E ratio above the benchmark – on December 31, 2018 the S&P/TSX Composite Index had a P/E of around 12.75 times earnings, according to S&P Capital IQ – then it’s more expensive than the market, and vice versa if its P/E ratio is lower than the benchmark.
While it’s useful to look at how expensive or cheap a business might be compared to a main benchmark, like the S&P/TSX Composite Index or the S&P 500, it’s also important to compare a company’s P/E with other businesses in its sector. For instance, high-growth technology stocks tend to have higher ratios than slower growing utility sector companies. Why? Because investors will pay more for company that’s expected to grow faster in the future.
It’s important to know that companies that have higher P/E ratios tend to fall harder when the market declines, which is exactly what’s happened with technology stocks in 2018. Many of the companies with high P/E ratios, such as Amazon and Netflix, saw big price drops. Why? Because when people think that global growth will slow, as they did in 2018, companies that are expected to grow the fastest can get hit the hardest.
Less expensive stocks, which the famed value investor Warren Buffett likes to own, tend not to fall as much because they’re already trading at a lower valuation. In other words, when it comes to P/E valuations, the bigger they are the harder they fall.
Things to remember
- P/E is a good first metric to look at, as it gives investors an idea of whether a stock is more or less expensive than the market.
- Companies with high growth potential tend to have higher P/E ratios and vice versa.
- If a company has no earnings, it will not have a P/E.
2. Enterprise value-to-EBITDA (EV/EBITDA)
P/E is a good place to start when picking stocks, but some analysts and fund managers prefer using enterprise value-to-EBITDA (earnings before interest, taxes, depreciation and amortization), which compares a company’s total value to its earnings before interest, taxes, depreciation and amortization.
People like using this metric because it doesn’t take into account a company’s capital structure, which is the way a firm finances its overall operations. As a result, investors can more easily compare companies, both inside and outside of their sector, with varied capital structures.
As with P/E, a lower EV/EBITDA number can signal undervaluation, while a higher one can be a sign that a company is overvalued. Valuations will also depend on the sector. Technology and biotech tend to have higher EV/EBITDA multiples than utilities and industrials. For instance, on December 31, 2018, the S&P 500’s EV/EBITDA was at 11 times, while the tech sector was trading at 12.4 times and utilities at 11 times.
Things to remember
- Many investors look at P/E and EV/EBITDA to determine whether a company is cheap or expensive.
- Because EV/EBITDA includes debt, it can be used, by businesses and investors, to determine whether or not a company is an attractive takeover target. The lower the multiple the better.
- EV/EBITDA can help investors compare stock valuations across sectors.
3 & 4. Price-to-sales (P/S) and price-to-book (P/B)
Other key valuation metrics include price-to-sales and price-to-book. The former compares a company’s share price to its annual revenues, while the latter indicates what an investor might pay for a business if it was sold off today.
Both are useful metrics to look at when deciding whether to purchase the stock of a company. P/S is often used to value companies that generate sales, but have low or no earnings. P/B is typically used by value investors to determine if a company’s stock is trading at below what its assets, minus liabilities, are worth.
P/S is a good metric to use when comparing businesses in the same sector and when trying to evaluate start-ups that aren’t yet generating a profit. P/B works well for capital intensive operations, such as financial, energy and transportation businesses. It’s not as useful for, say, tech or service-based companies that are built on intellectual property rather than assets.
As with other valuation metrics, lower numbers can signal undervaluation, while higher ones may be a sign of overvaluation.
Things to remember
- A low P/B may be a sign that a company’s assets are inflated. In that case, a low ratio may be a red flag.
- However, a low P/B may mean that it’s earning a low return on its assets, which management can work at rectifying. In that case, a low number could be a sign that it’s an attractive buy.
- Use P/S when trying to value start-ups or other early-stage companies that may have revenues but no profits.
5. Debt-to-equity ratio
Just like with people, businesses can hold debt that will eventually need to be repaid. While leverage can be useful – companies can borrow money to finance a new project, for instance – being overleveraged can be a problem.
That’s where the debt-to-equity ratio, which is calculated by dividing a company's total liabilities by its shareholder equity, comes in. The ratio, which compares a business’ debt to the value of its net assets, can help investors determine the indebtedness of a firm. A lower number means the company is in less debt, while a higher number means it’s in more.
Debt-to-equity ratios can vary by industry, so it’s best to use this metric when comparing companies in the same sector. Utility and telecom businesses, for instance, tend to have higher D/Es, because they’re capital intensive operations. However, both sectors have steady revenue sources – monthly cell phone bill payments in the case of telecoms, for instance – so a high D/E may not be a problem, as long as it can service that debt.
Things to remember
- High debt isn’t always bad, but D/E ratios should at least remain relatively constant. If a D/E ratio is rising over time, then that may be a problem.
- Many companies will see their D/E ratio spike after an acquisition, as it can cost a lot to buy another company. That can be OK, as long as management has a plan to pay back its debt.
While there are many other metrics to look at, most investors won’t have the time to dig into them all, though only looking at one isn’t enough. These five are a good starting point and should give investors a better idea of whether the companies they’re interested in would make a good addition to their portfolio.
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