You can use different metrics to get different insights into a company and its finances. While every metric has its place in a company’s financial storytelling, some by themselves can be a bit misleading and might not give the full picture needed before making an informed investing decision. Here are three to watch out for.
For stocks that pay out dividends, the dividend yield is one of the most advertised metrics. The problem with just the dividend yield, however, is that it fluctuates with a stock’s price. Companies set their annual dividends as a dollar amount broken down into four quarterly payments. If a company’s annual dividend is $2 and its stock price is $100, the dividend yield is 2%. If the stock price drops to $50, the dividend yield is now 4%.
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From the outside looking in, a 4% dividend yield looks pretty lucrative, especially if you’re unaware that the reason it’s that high is because the stock dropped 50%. Something could’ve fundamentally changed with the company that now makes it a bad investment, but if you only looked at dividend yield without knowing (or considering) that, you could put yourself in a position to lose money.
2. Price-to-earnings (P/E) ratio
The primary goal of someone focused on value investing is finding companies whose stock price is trading lower than their intrinsic value. One metric many value investors rely on is the P/E ratio, which is found by dividing a company’s share price by its earnings per share. The higher the P/E ratio, the more investors are paying for each dollar of a company’s earnings. Because of this, it’s often used to determine whether a stock is undervalued or overvalued.
The P/E ratio is a good metric for finding undervalued stocks, but looking at it by itself is misleading. To really understand if a stock is undervalued, you need to compare its P/E ratio to similar companies in its industry. Some industries have higher P/E ratios across the board than others, so it would be an apples-to-oranges comparison.
For example, it’s common for construction companies to have P/E ratios in the 30s, but it would be strange (and a deal breaker for most investors) to see a bank that high. You wouldn’t want to compare Vulcan Materials (NYSE: VMC) to JPMorgan Chase (NYSE: JPM).
3. Net profit
A company’s net profit is the money left over in a given period after paying for operating expenses, cost of goods sold, taxes, and interest. Generally, the higher a company’s net profit, the better, but sometimes this figure can be inflated because of one-off events that don’t give a true picture of a company’s usual operations.
For example, the Australian company Mirvac (ASX: MGR) increased its net profit from $447 million to a little over $1 billion (69%) in 2016, but it was almost all because of the value of its property investment portfolio rising; its operating profit only increased by 6%.
When examining a company’s profits, it’s best to examine net and operating profit because it gives a more complete picture. Each is important in its own right, but they’re best used together.
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