When I first started looking at investing in stocks, I really didn’t know much about them. I basically looked up local companies that I had heard of and then looked at the historical graph to see if their value had been consistently increasing. If it showed growth in the past year or two, I invested. If it showed a decline, I chose not to invest. It really was a terrible model and I would not recommend it to anyone!
By the way, if you must know, I did make a cool $85 with these investment decisions. Ha ha. It doesn’t sound like much, but it wasn’t too bad considering I only invested $400. In short though, I was lucky. Don’t do what I did.
Three Key Financial Ratios to Look at Before Investing
Before you invest, get educated and take a look at a few of these ratios before investing your hard-earned money into the various funds that you choose. We’ve discussed valuation ratios before, but these are other metrics that you should look at before investing.
1. Price-to-Earnings Ratio
You’ve most likely heard of EPS, these are the earnings per share of a company. In other words, they take their net earnings and divide that by the number of shares that are outstanding and come up with a number.
For the company I am most familiar with, their EPS is typically about .40. To get the price-to-earnings ratio, you simply take the current stock price divided by the EPS. With a stock price of $29, the price to earnings ratio is $29/.4, so their price-to-earnings ratio is 72.5. The higher the number, the worse it is. It is best to find a price-to-earnings ratio that is certainly less than 17, which is the historical average.
2. Debt Ratio
Companies that take on more debt are either trying to grow very quickly or are struggling to stay afloat in the demanding market. Either way, it is often more risky to invest in companies that have large amounts of debt. With such varying company sizes though, how can you tell if their debt load is large or small?
Calculate their debt ratio. Simply take their total debt amount and divide this number by the company’s total assets. If they have more debt than they do assets, it’s time to start paying close attention to the other ratios mentioned in this article. If the company has more than twice as much debt than they do assets (in other words, their debt ratio is over 2.0), I would personally steer clear of this stock as an investment option.
3. Price-to-Cash-Flow Ratio
One of the most important things to any organization (especially in difficult financial times) is cash. Without cash on hand, a company could quickly go from operating seamlessly to defaulting on their accounts payable and employee payroll. Without the appropriate cash, companies are in trouble. This is why the price-to-cash-flow ratio is so important. So what is it? It’s a simple calculation, and everything is available to you in the company’s cash flow statement.
Simply take the company’s total cash flow (this is easily found on the cash flow statement) and divide it by the number of shares owned by shareholders. Or, if you find a number that says, “cash flow per shareholder,” use that. Take the current share price and divide the cash flow per share. This will give you your price-to-cash-flow ratio. The lower number the better. Keep in mind that the average value is approximately 10.
Was this helpful for you? Have you used these ratios before?
Editor’s Note: Want to learn more about investing? Check out some of the best investing blogs of 2016!
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him here and here.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.