The 1 Investing Metric We Can't Do Without

By Markets Fool.com

There are hundreds of numbers to look at when analyzing a stock. However, some are more important than others.

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We asked three of our analysts to explain the one metric they can't live without. Here's what they had to say.

Selena Maranjian
One simple stock-analysis tool I use a lot is the price-to-earnings ratio. It's easily calculated, and it's often calculated for you on many online stock-quote pages. To arrive at a company's P/E ratio, simply divide its current stock price by its trailing-12-month earnings per share, also called EPS. The lower the ratio, the more cheaply the stock is valued, and vice versa.

The P/E is often referred to as a "multiple," as in, "Coca-Cola is trading at a multiple of 23." That's another way of saying that investors at the moment are being asked to spend $23 for each dollar of Coca-Cola's earnings per share. When a stock's price falls, simple math dictates that its P/E ratio will fall, too. If the price stays relatively steady and earnings grow, then the P/E will shrink, too. Thus low P/Es are handy indicators of stocks' value.

The P/E isn't perfect, though. It doesn't offer an apples-to-apples comparison among different kinds of companies. For example, slow-growing, capital-intensive industries like auto manufacturing tend to have low average P/Es -- often in the single digits. Meanwhile, faster-growing industries like software and biotechnology often feature relatively steep P/Es in the 30s or above. Keep in mind, too, that a P/E ratio depends heavily on a company's EPS, which can be manipulated (legally or illegally) by the company. If a company buys back lots of its shares, for example, its EPS will rise.

I often glance at companies' P/E ratios for a quick sense of whether they may be over- or undervalued. It can be a good starting point in your search for portfolio candidates.

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Leo Sun
Dividend investors should acquaint themselves with the payout ratio, which measures how generous a company's dividend payments are.

The first way to calculate a company's payout ratio is to divide dividends paid per share (quarterly or annually) by earnings per share during the same period. However, because accounting noise can distort EPS, some investors prefer calculating the payout ratio using free cash flow, which is done by dividing trailing FCF by total dividends paid over a certain period.

If the payout ratio remains above 100% over several quarters, it means that the dividend is not covered by earnings and could therefore be reduced in the future. And the higher the payout ratio, the less room the dividend has to grow in the future. Meanwhile, a low payout ratio indicates that the dividend has plenty of room to grow. However, if the company is not deploying that leftover cash to grow the business, then perhaps it's being stingy with shareholders. Generally, a payout ratio between 30% and 70% is considered reasonable and sustainable.

Payout ratios should never be compared across different industries. For example, slow-growth big tobacco companies will almost always have a higher payout ratio than higher-growth media companies. Instead, payout ratios should be compared only between comparably sized industry peers.

Dan Dzombak
The one metric I can't live without is the enterprise value-to-EBITDA ratio. Too often people look at companies' earnings without looking at the balance sheet, and this ratio takes into account both the company's market capitalization and its balance sheet, giving you a better idea of a stock's valuation.

Enterprise value is calculated by adding debt to the company's market cap and then subtracting cash and cash equivalents. This calculation gives you an idea of the company's total capitalization.

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It's a substitute for calculating a company's cash flow, though it's definitely an imperfect substitute for equity holders, as interest, taxes, and depreciation are all real cash expenses.

Two examples of the EV/EBITDA ratio in action are instructive. Ford is trading at a P/E ratio of just under 10 -- cheap, right? However, if you take into account the company's massive amount of debt, the stock trades for a whopping 19.5 EV/EBITDA.

F EV to EBITDA (TTM) Chart

On the flip side, Apple is trading for a P/E of 17. However, the company has over $130 billion of excess cash on its balance sheet, so the stock trades at an EV/EBITDA ratio of 10.7.

AAPL EV to EBITDA (TTM) Chart

While an EV/EBITDA ratio of 10 is not stunningly cheap, I'd say anything under six comes close.

Investors shouldn't ignore companies' balance sheets, and the EV/EBITDA ratio helps make sure you don't.

The article The 1 Investing Metric We Can't Do Without originally appeared on Fool.com.

Dan Dzombak has no position in any stocks mentioned. Leo Sun owns shares of Apple. Selena Maranjian owns shares of Apple, Coca-Cola, and Ford. The Motley Fool recommends Apple, Coca-Cola, and Ford; owns shares of Apple and Ford; and has options on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.