Investors shouldn't go in blind to the stock market. To that end, there are many indicators out there to help investors understand whether a company is coming up or sliding down. Indicators also make it easier to compare companies.
These indicators can roughly be bunched into two categories: technical indicators and fundamental indicators (aka fundamental ratios). The goal is to condense information about a stock into a quick number that investors can refer to. Of course an investor can also research to get the story behind the numbers by reading company reports.
Technical vs. Fundamental Indicators
This all raises the question, “What kind of indicator is best?” Unfortunately, like most things in investing the answer depends on who is asking.
Some traders are in and out of dozens of stocks in a short time frame. For these players, understanding deep fundamental metrics is less critical because they are short-term holders. Technical analysis (trends and price performance) matters more to these people than does a company's fundamentals.
In contrast, someone looking for an investment that they plan to buy and hold, will look at the company as a business rather than just a stock. These investors hope to find a company that has a lower chance of going bankrupt and a higher chance of growing its earnings. Fundamental indicators provide an excellent starting point or a filter to narrow down a list of prospective investments before buying.
Finally, there is no rule about mixing these two indicators together. Some long-term investors use technical indicators in order to pick the best possible price at which to buy or sell. They hope to increase their portfolio performance by mixing both kinds of indicators .
Multiple research studies have found that changes in a company's earnings drive a significant percentage of long-term stock price movement. So, when choosing a long-term investment, it pays to look at the current earnings as well as earnings potential.
Indicators let investors compare how cheap or expensive it is to buy a portion of the company's earnings. Use these ratios to find the cheaper of two similarly-sized companies in the same industry.
Price to Earnings Ratio (P/E)
The P/E Ratio is probably the most oft-quoted ratio on all companies. Generally speaking if you look up any stock, this ratio will be front and center. Because it is so widely-followed, it pays to look at this whether considering industries, specific companies, or the stock market in general. In short, this ratio tells you how many dollars you're paying per dollar of earnings.
If you want to calculate the P/E yourself, start with market capitalization. This is the number of shares outstanding multiplied by the price per share. Then divide that figure by the earnings (or net income) of the company.
As a general rule, companies with a low P/E are considered cheap, while ones with a high P/E are considered expensive. Of course there could be reasons for either. A company may have a low P/E because the market does not believe that the company will materially grow its earnings in the future. But high-growth companies generally sport high ratios since investors price in much higher earnings in the future and bid up the price today despite little to no earnings.
As mentioned, investors often use the P/E to compare companies within the same industry. They also compare the ratio to its historical range to deduce over- or undervaluation. For example, at the height of the tech bubble, Coca Cola, a stable blue-chip company, had a P/E of 54, a high number usually reserved for high-growth stocks. This was of course a function of the general frothiness in the markets. But investors who noticed this abnormality avoided the painful 50% drawdown that followed as the bubble burst.
Earnings Per Share (EPS)
Similar to the P/E, Earnings per Share (EPS) is another way of tracking how a company is doing. To find a company's EPS, you simply divide its earnings by the number of outstanding shares.
The EPS method is best for tracking a company's performance rather than comparing it to other companies. This is because you generally want to see the EPS of a company go up over the long term.
This shows that its earnings are growing over time. Likewise a stagnant or declining EPS is cause for investors to find out whether a company is encountering a short-term issue or something more concerning.
Price to Earnings Growth (PEG)
Many investors see the PEG as an improvement on the traditional P/E. The PEG attempts to account for a stock's growth in earnings, which is an important component of future returns.
Accounting for growth is also important because high-growth companies often hold very high P/E due to the market's belief that the majority of earnings are to come in the future. Such a high price to earnings multiple may put off a lot of investors. So the PEG attempts to show whether that high P/E is justified due to the future growth of the business's earnings.
In short, if the P/E tells us how much we are paying per dollar of earnings, the PEG tells us how much we are paying per unit of expected growth in earnings. It basically adjusts the P/E for growth.
Generally the lower the PEG, the better, as you are able to buy more earnings growth for fewer dollars. This is important to keep in mind when comparing different growth stocks using the PEG. Likewise, if there is a growth stock that happens to have a sky-high P/E, you can look at it under the lens of the PEG to get a sense of whether it's still overvalued when factoring in growth.
Balance Sheet Indicators
Using a company's balance sheet to gauge the attractiveness of an investment has been a favorite since Ben Graham revolutionized value investing in 1934.
The reason we rely on the balance sheet is that earnings, revenue and other income-related items can be easily manipulated through accounting tricks in order to hide potential risks in a business model. The assets a company owns, however, are much easier to value and they are controlled by the company.
This means investors don't have to try to project how the asset will do in the future, as it already exists. Because assets can be valued effectively, they also tend to provide a conservative estimate of the business's worth.
Debt-to-Equity Ratio (D/E)
Looking at debt is crucial because the biggest risk a company faces is bankruptcy.
The D/E, as the name implies, takes the total debt of a company (long-term and short-term liabilities, as well as any other fixed payments) and divides it by the company's equity (aka shareholder equity). This gives an investor an easy way to compare how indebted different companies are.
Companies can raise capital in two ways: debt and equity. Debt means taking out a loan from a bank or selling bonds. It means the company must make fixed payments for the period of the loan. The debt holders also have first dibs on any assets if the company goes bankrupt.
The second way to raise money is for the company to sell additional shares. While this doesn't come with fixed payments or obligation to debt holders, this does dilute existing shareholders' equity, which can lead to a negative reaction in price.
D/E simply looks at the ratio between the two. A company that relies almost exclusively on debt doesn't dilute its shareholders' equity. But it may have put itself in a precarious position where all of its income goes to paying back debt.
Price-to-Book Ratio (P/B)
The P/B compares a company's market value to its book value. It's calculated by dividing the share price by the book value per share. Book value refers to the sum of all of a company's assets minus all of its liabilities.
This ratio is a number that is almost always higher than 1 since the market prices a company on its future rather than on its present value. Book value looks at the current value of assets and liabilities. But the market value is forward looking and incorporates the earning power of the business going forward.
Value investors generally look for companies trading at a lower P/B and especially those that trade below 1. Despite the logic for why a P/B almost never goes below 1, it still does happen, usually as a result of financial distress or market worries about a business's future earnings potential. This can lead the price per share to converge with the company's book value.
The P/B is useful for finding potential bargains. But it's important to note that something must have happened in order for the P/B to drop. An additional thing to keep in mind is that P/B across industries is different. The oil and gas sector for example is very asset heavy and so has a high book value. The tech sector is asset light and so has a low book value.
The current ratio is a simple metric that compares a company's current assets to its current liabilities. A current asset is one that is expected to be converted into cash in 12 months or less, while a current liability is one expected to be paid off in 12 months or less.
In essence, this ratio shows investors how well equipped the company is to pay off all of its near-term debts. This is important because as we mentioned, when a company cannot cover its debts, bankruptcy likely follows. A current ratio higher than one means that the company shouldn't face any issues within the next 12 months.
It's important to note that a current ratio higher than 1 doesn't automatically mean that a company has a low bankruptcy risk. The company could still have a very heavy long-term debt burden that is eating up all of its earnings.
Some readers will notice that many of these indicators have a focus on earnings. But not all companies have earnings.
In particular, early-stage companies often forego the maximization of earnings in order to reinvest and grow faster, whether through R&D or acquiring customers. This raises the question, “What indicators can be used when there are no earnings?”
The solution, while not a perfect one, is to use EBITDA (earnings before interest, tax, depreciation and amortization). Oftentimes high-growth companies will post positive EBITDA and negative earnings due to the reasons outlined above.
In rare cases where EBITDA is also negative, investors can substitute it with revenues. It is important to note however that the farther one strays from using pure earnings, the more an accounting gray area is being relied upon.
Fundamental analysis indicators provide useful and quick tools to compare similar companies, be it similar in size or in the same industry. Another use for indicators is to filter a list of potential investments for companies to look further into.
Perhaps you want to avoid any companies that happen to have a high debt burden. Or maybe you want only companies that have grown their EPS for four consecutive quarters. Indicators can help you do that in a quick and efficient way.
- How to Evaluate Stocks and Stock Ratios
- Financial Ratios — What Are They and How to Read Them?
- What to Look for When Buying Stock