4 Fundamental Metrics Every Investor Should Understand

By Markets Fool.com

It's important to know what you're looking at when you read a stock quote, beyond the obvious numbers like share price and 52-week high/low. Some metrics, like dividend yield, are good to know for any stock, while others are more specific to certain kinds of stocks.

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We asked four of our analysts to explain some metrics that every investor should know and understand, and here is what they had to say.

Eric Volkman: For income investors, few financial metrics are more critical than dividend yield. It tells us at a glance the payout rate we'll get for owning a stock at a particular price.

We calculate this using the company's current per-share dividend, annualized, then divided by the stock price. So, for example, Coca-Cola's current quarterly payout is $0.33 per share. We multiply this by four in order to get the annualized rate -- $1.32 -- and divide it by the current share price ($41.12). The result is the dividend yield, 3.2%.

It nearly goes without saying that, all things being equal, a higher dividend yield is preferable to a lower one. But of course, on the stock market, very few things are equal. A stock might boast a relatively high yield due to weakness in its share price following disappointing results, for instance.

Taking the example of Coke, the company has had trouble meeting key analyst estimates over the past year, among other problems; as a result, its stock has only inched up 1% during that time, compared to 11% for the S&P 500. On the flip side, a well-performing company might see a run-up in its stock price, depressing its yield.

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Dan Caplinger: Free cash flow is one of the most misunderstood financial metrics out there, yet it can be crucial to understanding how a company actually makes money. By looking at free cash flow, you can escape some of the artificial distortions that GAAP earnings have and get a better picture of how much cash a company really has available.

For instance, if you look at a stock like Frontier Communications and rely solely on GAAP earnings, you'll quickly conclude that its dividend is extraordinarily high compared to its earnings and, therefore, that it's risky from an income perspective. Yet like most telecoms, Frontier has huge amounts of depreciation and amortization, which reduce earnings but don't cost the company any cash. When you add back in the $1.2 billion in depreciation and amortization that Frontier has taken in the past year, the telecom's free cash flow makes it clear that it can afford the payout it's currently making.

Whenever you have a dividend stock with a high yield, be sure to check the free cash flow the company generates. Often, it'll give you a better sense of whether the company can sustain its payout over the long run.

Jason Hall: Dividends are an important part of the return for stock investing. As you can see in the chart below, nearly half of the S&P 500 index's total return since 1990 is from dividends:

^SPX Chart

And since dividends are so important, it's important to have a metric to measure a company's ability to maintain or even increase its payout. That's where the payout ratio can come in handy.

What is the payout ratio? In short, it's the percentage of earnings paid as dividends. It's pretty easy to calculate, too, using information available in a company's annual and quarterly earnings reports. Simply divide dividends per share by earnings per share. The percentage you get is the payout ratio.

However, it's important to note a few things about the payout ratio. To start, it's not a "one size fits all" metric. As Dan Caplinger notes above, earnings can be skewed by non-cash factors that can make a payout ratio appear both wildly unsustainable, and safer than it may really be.

The best use of the payout ratio is in concert with other cash-flow based metrics and looking at trends, not just a single quarter or even year's results. You also need to consider the industry, since some (like steelmaking and consumer retail) can be very cyclical. This makes it important to consider the future prospects, just as much as the past results.

Matt Frankel: One metric (well, actually two) that investors should know is price-to-book (P/B), as well as its close cousin price-to-tangible-book (PTBV). And, this is especially important if you invest in bank stocks or other finance-related businesses.

Price-to-book is exactly what it sounds like. It is calculated by dividing the current share price of a stock by its book value per share. And, book value is the total value of a company's assets. Tangible book value is almost the same thing, but excludes "intangible" assets like patents, intellectual property, and goodwill.

In general, the higher these numbers are, the more "expensive" the stock is, and an excessively low price-to-book could imply there is something fundamentally wrong with the stock.

In the banking industry, the price-to-book ratio tends to correspond to the profitability of the bank, and is one of the most widely used metrics to value bank stocks. Banks with high P/B or PTBV ratios tend to have high return on equity (ROE), meaning they're more profitable. For example, consider the P/B ratios of the "big four" U.S. banks and their ROE.

Bank Symbol Price-to-Book Return on Equity (ROE)
Bank of America BAC 0.77 2.2%
Citigroup C 0.83 3.7%
JPMorgan Chase JPM 1.15 10.6%
Wells Fargo WFC 1.75 14.5%

Source: YCharts. Note: Data is current as of 6/3/15.

In a nutshell, investors can expect banks with high P/B and PTBV ratios to be the most profitable, so they are a good metric to know when examining bank stocks.

The article 4 Fundamental Metrics Every Investor Should Understand originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. Eric Volkman has no position in any stocks mentioned. Jason Hall owns shares of Coca-Cola and Wells Fargo. Matthew Frankel owns shares of Bank of America. The Motley Fool recommends Bank of America, Coca-Cola, and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.