3 Measurements To Understand Before Investing In A Business

Important points

  • P / E is calculated by dividing the share price by earnings per share. shares.
  • High leverage is a red cloth.
  • Dividend payments of more than 100% are not sustainable in the long run.

Different measurements can give you insight into different areas of a company’s operations and financial health. Externally, it may seem to be going well, but a look at a company’s balance sheet often reveals that all that glitters is not gold.

This does not mean that you have to know a company’s finances inside and out, but there are a few metrics you should know before making an investment decision.

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1. Relationship between price and earnings (P / E).

The price-to-earnings ratio (P / E) is a simple metric for finding undervalued or overvalued companies. Instead of just looking at the price of a stock – which can be misleading because there are “expensive” $ 20 stocks and “cheap” $ 500 stocks – P / E gives you a better idea of ​​a company’s value. You can find P / E by dividing the share price by earnings per share. share (EPS).

You can not use a company’s P / E alone, you have to compare it with other companies in the same industry. Comparing companies from different industries is often like comparing apples to oranges. had e.g. Apple recently a P / E ratio of around 24, Microsoft on the other hand, a P / E ratio of 28.5. If you want to know evt Delta Airlineswhich recently had a P / E of 53 is underestimated and it would be misleading to compare it with these companies.

2. Debt in relation to equity

It is common for companies to finance their businesses by raising debt, but when the debt level gets too high, it is a red flag. A company’s debt in relation to equity reflects how large a part of the company’s operations is financed by debt compared to the owners’ investments and retained earnings. To calculate leverage, divide the total debt by equity. The higher this goal is, the greater the risk the company takes.

If a company has $ 100,000 in debt but $ 1 million in equity, the leverage ratio is 0.1 and it is considered a low-geared company. If it were the other way around and the company had $ 1 million in debt and $ 100,000 in equity, the leverage ratio would be 10, meaning the company is almost exclusively financed by debt.

Although you typically aim for lower leverage, extremely low leverage can mean the company is too conservative and keeps on for too much money instead of using them for continued growth. Whether it’s research and development, logistics or acquisitions – all of these things can help a business grow, but it can not be done without spending money. Being stingy now can be very expensive in the future.

Payout ratio

If you want to invest in a dividend-paying company, you need to know the company’s dividend percentage, which tells you how much of its earnings are being paid as dividends. To calculate the payout ratio, divide a company’s annual dividend by its earnings per share. If a company’s annual dividend is $ 5 per share. share, and earnings per. share is $ 20, its payout ratio is 25%.

If a company has a payout ratio of 100%, it means that it pays out all of its earnings in the form of dividends; if the rate is above 100%, it means that it spends more than it absorbs – which, as you can imagine, is not a good thing. As a rule of thumb, a payout ratio of between 30% and 50% is a good mix of shareholder rewards, while providing adequate reinvestment in the company.

Younger companies typically do not pay dividends because they have to put the money back into the company to continue growing. Older, more established companies have less room for excessive growth and are less likely to see their stock price rise exponentially. To offset this, they pay dividends to reward shareholders for holding on to their shares.

For many investors, dividends make up a large portion of the total return. Make sure you know a company’s payout ratio so you know if it’s sustainable in the long run.

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This article was written by Stefon Walters and was published on Fool.com on 6/2/2022. It has been translated so that our German readers can participate in the discussion.

The Motley Fool owns shares in and recommends Apple and Microsoft. The Motley Fool recommends Delta Air Lines and recommends the following options: long March 2023 $ 120 calls on Apple and short March 2023 $ 130 calls on Apple. .

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