Whether you're just beginning to invest or are a seasoned investor, evaluating stocks can be a daunting task, due in part to the hundreds of metrics out for gauging a company's worth. However, while the number of metrics may make investing look complicated, not all of them are truly useful when you're looking for stocks worthy of your money and time.
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To help you invest better, we asked our contributors to explain the three most important valuation metrics that every investor should understand: the price-to-earnings ratio, enterprise-value-to-free-cash-flow ratio, and price-to-cash flow ratio.
P/E ratio: An easy-to-use, useful metric
Keith Noonan (Price-to-earnings ratio): The price-to-earnings ratio is one of the most common metrics for evaluating a stock, and while it's not a helpful indicator in every scenario, it can provide insights on how the market values a company's earnings.
As the name implies, the P/E ratio is derived by taking the price of a share of stock, and dividing it by the annualized earnings per share. This value can then be compared to other P/Es, whether of an index, industry, or an individual company. A relatively low P/E may be an indication that a stock is undervalued compared to its earnings, while a high P/E might suggest the opposite. As an example, Cisco Systems' (NASDAQ: CSCO) forward P/E of roughly 14 suggests the stock is inexpensive when compared to the networking and communications hardware sector's average of 24.7 and the S&P 500's average forward earnings multiple of roughly 18.
Confused about valuation metrics? Knowing the important ones helps. Image source: Getty Images
P/E ratios are used to evaluate price in comparison to both past performance and anticipated returns. Trailing-12-month P/E is calculated using actual earnings over the last four quarterly reporting periods, while forward P/E typically is derived using expected earnings over the next fiscal year or 12-month period. Stock prices are forward looking, and past performance won't necessarily be repeated, so forward P/E is often a better indicator than trailing P/E. However, the company guidance and analyst expectations used to estimate future earnings often disagree, and both can be inaccurate
P/E ratios can be useful tools, but they won't provide meaningful insights in every situation. Companies that are young or otherwise undergoing periods of rapid expansion or high spending might have small profits or still be posting losses, and price-to-earnings ratios don't provide a useful point of comparison for the value of an equity in these instances. Earnings can also be affected by accounting practices and other factors, so digging deeper into a company's operations and financials and using other metrics to supplement the information presented by P/E values is essential.
EV/FCF ratio: A metric that matters to business owners
Chuck Saletta (Enterprise-value-to-free-cash-flow ratio): When you own a company outright, you care about your total capital structure -- your debt and your equity. You also care deeply about how much cash the company is generating, as cash is frequently much more valuable to a business than accounting profits are. That combination is what makes the enterprise-value-to-free-cash-flow ratio such a powerful one to look at for investors who want to act and think like owners rather than speculators.
Start with the enterprise value side of that ratio. To calculate the enterprise value for a company, start with its market capitalization, then subtract any cash and equivalents and add any debt, minority interest, and preferred shares. That basically tells you what the market is valuing the company at in a takeover situation, as any new owners would benefit from its cash or be responsible for its debts.
While there's no official definition of free cash flow, a common approach to calculating it is to start with a company's cash from operations and subtract any capital expenses. Cash from operations measures how much cash a company generates from running its business, while the capital expenses acknowledge that generating that cash generally requires ongoing investments in growth and renewal of equipment.
Calculate theenterprise-value-to-free-cash-flow ratio by dividing the enterprise value number by the free cash flow number. The ratio can be more valuable in some situations than the more common P/E ratio, as it looks at the bigger picture of things that typically matter more to true owners.
The table below shows how you would calculate the ratio for technology giant Apple (NASDAQ: AAPL). Note that Apple's EV/FCF ratio of 14.8 is below its price to earnings ratio of 16.3. Since Apple carries more debt than it has cash and equivalents, that lower EV/FCF ratio indicates that Apple is doing a strong job of converting the revenue in takes in into cold, hard cash.
Table by the author
Still, the usefulness of the EV/FCF ratio to investors has limits. Chief among them is that unless you have enough of a stake to truly influence the company's use of its cash and capital structure, you have no control over with it will appropriately use its cash or avoid overleveraging on debt. In addition, the free cash flow number can be juiced in the short term by underinvesting in maintenance expenditures. Those short-term gains can lead to long-term pain as equipment ages.
Despite those limits, the enterprise-value-to-free-cash-flow ratio is an incredibly useful metric for investors who want to view their investments through the lens of the business owner. Even if you don't control what the company does with its cash, you can at least use changes in the numbers that make up that measure over time to help you judge whether you think its management is putting its cash to good use. And that's a number worthy of the time it takes you to calculate and track it.
P/CF ratio: Loss-making companies can be valuable too
Neha Chamaria (Price-to-cash-flow ratio): My fellow Fool Keith Noonan rightly pointed out how popular the P/E ratio is as a valuation metric, but as he also stated, several factors can impact earnings. More importantly, earnings, as reflected on profit-and-loss statements, can be manipulated by way of non-cash expenses, distorting the true picture of a company's financial health.
What matters more to investors is a company's operating cash flow, which excludes non-cash items to reflect the actual cash a company generates from core operations. After all, it is this cash that the company uses to pay debts, reinvest in the business, or return to shareholders via dividends and share buybacks. That is why I always consider cash flow while analyzing a company, and price-to-cash-flow ratio when valuing a stock.
To compute the P/CF ratio, all you have to do is divide a company's stock price by its cash flow per share. To derive that, simply look up the company's cash flow statement to find its cash from operations or net cash provided by operating activities, and divide that by the number of shares outstanding to get the cash flow per share. While there's no standard to define an "attractive" P/CF, a lower ratio is generally better when looking for value stocks.
More often than not, a stock that you may write off as pricey based on its P/E ratio could prove a lot more attractive in terms of P/CF, as appears to be the case with the broader markets right now. Here's a solid example to help you understand why: Caterpillar Inc. (NYSE: CAT).
The heavy-equipment manufacturer's stock has soared a staggering 50% in the past year, as of this writing. Given the persistent headwinds in the mining and oil and gas sectors, Caterpillar's rally and the consistent flow of ratings upgrades from analysts have left many investors bewildered. After all, how can a company with a trailing P/E of 88 or a forward P/E of 33 be undervalued -- especially if its earnings are expected to decline this year?
Enter the P/CF ratio. You'll be surprised to see how dramatically different things suddenly appear when you measure Caterpillar's based on its P/CF.
At only 10 times P/CF, Caterpillar is anything but overvalued. While Caterpillar's net earnings have slumped in recent years, it continues to generate strong cash flow. For perspective, Caterpillar generated almost $5.6 billion in operating cash flow compared to net losses worth $59 million during the trailing 12 months. That also explains how Caterpillar has maintained its dividends despite plunging profits.
Of course, no valuation metric is foolproof, including the P/CF ratio, but it's especially useful in analyzing companies that aren't profitable or have taken big hits to their bottom lines primarily because of macro factors, as is the case with Caterpillar. You could even go a step further and use the price-to-free-cash-flow ratio. (Psst... Caterpillar isn't insanely valued on a P/FCF basis either. Don't believe me? Go compute the ratio now that you've learned about cash flows.)
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Chuck Saletta owns shares of Cisco Systems. Keith Noonan has no position in any stocks mentioned. Neha Chamaria has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Cisco Systems. The Motley Fool has a disclosure policy.