Minding Your Metrics: PEG, Book Value, Debt-Equity, and More
Today, we’re going to focus on vital metrics that can help investors do everything from set filters for broad research to dive into the numbers for a specific firm. The News Quantified platform itself doesn’t focus on these sorts of value-centric numbers (they’re readily available from free resources, and likely your broker, and we prefer to focus on the unique value of our dataset), but they can be valuable tools for researching potential data-driven trading strategies.
Rather than trying to rely on a “magic rule” for specific metrics, it’s better to have the knowledge necessary to get a quick read on many of them. A single metric can be misleading for a particular stock due to anything from a strange accounting practice to a unique business model. By taking a broader view, you prevent outlier data points from misleading your appraisal of an equity. As always, comparisons between the same sector are more likely to be directly relevant.
- Price-to-Earnings Ratio: This one is so widely discussed we dedicated an entire blog post to it. While a solid back-of-the-envelope method for comparing profits to stock price, this metric has vital limitations that far too many beginning investors seem to ignore.
- PEG Ratio: Meaning “Price-to-Earnings Growth,” this metric attempts to ameliorate some of the fundamental deficiencies of P/E ratio by looking a growth. It’s certainly a more complete metric, but introduces all the uncertainties surrounding estimating future earnings in the first place.
- Price-to-Book Ratio: Rather than focus on profits, the Price/Book ratio compares the stock price to net assets. You can roughly think of “Book Value” as the money a firm could command if it ceased operations and sold all assets. This metric is most valuable when searching for undervalued stocks; successful firms will have a market value well in excess of their book value due to their ability to generate earnings growth. Struggling firms, however, can have their Price/Book ratio drift below 1. This begins attracting a different sort of investment—rather than believe in the company’s future success per se, investors may believe they can acquire assets (often even cash) at an attractive price.
- Price-to-Tangible Book Ratio: Traditional book value has a key limitation in today’s economy: many firms retain vast intangible assets designed to capture, for instance, the value of their brand. This value may or may not end up being “real,” but it certainly gets away from the spirit of Book Value, which is supposed to function as a sort of theoretical floor for the value of the stock. The “Tangible” Book ratio strips out all intangible assets, providing a more conservative valuation.
- Debt-to-Equity Ratio: This metric compares outstanding debts to equity. Since equity represents shareholder interest in the firm, this ratio effectively compares a firm’s debt to its value for ownership. A high debt-load isn’t inherently bad—it may be warranted if the firm is expanding fast, and higher debt loads are the norm for more capital-intensive industries. Higher debt loads do introduce risks, however, and higher leverage can be fatal for a firm that can’t continue generating earnings growth.
- Free Cash Flow: This metric looks at the amount of cash leftover after operating and capital expenditures are subtracted from revenue. That description may sound just like earnings; the difference is subtle but vital. Earnings include non-cash expenses like depreciation of assets (an expense in the sense that the firm will have to eventually replace the depreciating asset, but not an actual cash outlay). Free Cash Flow looks only at expenses that actually require expending cash. Formally accounted earnings may tell us more about the long term health of the firm, but Free Cash Flow is much more directly relevant to evaluate a firm’s short-term ability to maintain liquidity, service debt, and maintain operations without further financing.
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