With rising financial literacy, millions have started exploring the markets in the finance sector. Some view these markets as a way to mint money, whereas others want to establish a passive income flow. Either way, making investment decisions can be exciting yet intimidating, especially if you like taking risks. So, how do you navigate these markets and earn lucrative returns?
Even though there is no sure-shot way of earning profits in the financial market, understanding key metrics can help investors. It can determine if the investment is good enough and whether it will provide stable returns. But before we delve into the metrics, here is a brief overview of how the financial market works:
How Does the Financial Market Work?
A financial market is a place where securities and stocks exchange hands. It is a trading hub where people buy and sell equity in companies. Most markets are divided into two categories:
- Money market – Where traders deal in bonds and T-Bills.
- Stock markets – Where investors buy and sell shares. Stock markets comprise thousands of companies, offering their equity and yearly payouts as a dividend.
As an investor, you must determine which stocks and money market securities offer a high return potential. Based on this, you can start trading. However, identifying high-potential companies requires extensive research and business acumen, which is built over time. If you are new to the market, look for the best investment banking and valuation firm to get help with your investments.
At the same time, start learning about key metrics to analyze the market fundamentals. Here, we have outlined five crucial metrics that every investor should know.
1. Price-to-Earnings Ratio
The most common financial metric is the price-to-earnings (P/E) ratio. This ratio is at the bottom of every company’s profit and loss statement. It indicates the stock’s market value compared to the company’s earnings. Simply put, it shows how much the company is willing to pay its shareholders today based on its past earnings. For example, if the P/E ratio is $5.5:$1, the company is willing to pay $5.5 per share, offering a premium of $4.5.
By analyzing the P/E ratio, investors can determine whether the stock is overvalued or undervalued. A high ratio means the stock is expensive relative to earnings and may be overvalued. Similarly, a low P/E ratio means the stock has more potential, and the prices might increase in the future. It allows investors to decide when they should buy and sell the stocks.
2. Free Cash Flow
In finance, free cash flow is the money left after the company pays off its expenses. Hence, it reflects how efficient an organization is at generating cash, and for investors, it is a metric to determine liquidity. Investors must assess if the company has sufficient cash after funding its expenses to offer shareholders dividends and share buybacks.
Any investor with a long-term view must analyze this metric carefully. Free cash flows are an early indicator to determine if earnings will increase. If the company suffers from a liquidity crunch and relies on working capital finance to keep cash flow stable, dividends and payouts will also be low. Similarly, a rising free cash flow could reward investors in the future.
3. Earnings per Share
Most investors look at a company’s profitability when making investment decisions, but is that the right metric? Probably not. An organization making a profit of $10 million might seem lucrative, but do you know how much a single shareholder is earning? For this, you must calculate the earnings per share (EPS). It measures the company’s profitability per outstanding share of common stock. You can calculate this by dividing the company’s net income by the outstanding shares.
For example, if a business has an income of $200 million and pays out $4 million in preferred dividends, it would be left with $196 million. This $196 worth of income shall be divided amongst common stockholders. If there are 50 million shares of common stock, the EPS would be $3.92 per share ($196/50). Looking at this, the investor can determine if they will earn sufficient returns over time.
Lastly, higher profits do not mean higher EPS. A company can generate higher EPS by repurchasing its shares without additional net income. Hence, you must assess these metrics carefully.
4. PEG Ratio
Another metric every investor should measure is the price/earnings-to-growth (PEG) ratio. It is an advanced version of the P/E ratio that accounts for growth. It measures the relationship between the P/E ratio and earnings growth, giving investors an idea of stock valuation. After all, it analyzes today’s earnings and the expected growth rate.
A stock with a PEG ratio of less than one is mainly categorized as undervalued because the price is lower than the company’s expected growth. On the other hand, a ratio greater than this can be overvalued since it indicates the stock price is high. This metric provides a forward-looking perspective to investors, helping them decide if it is worth investing in the stock.
5. Debt to Equity Ratio
As an investor, you might come across companies offering hefty dividend payouts, but that alone isn’t enough to make an investment decision. Often, companies offering high returns are highly reliant on debt. Therefore, another metric you must consider is the debt-to-equity (D/E) ratio. It determines how a company finances its assets, showing the proportion of equity to its debt.
A low ratio means the company has low long-term liabilities, reflecting a stable market position. At the same time, a high ratio means the company derives most of its financing from debt. It poses a risk that they don’t have sufficient cash to meet the debt obligations.
However, remember that the D/E ratio varies from industry to industry. In some sectors, a D/E ratio of 40% is considered high, but in others, it is average. It all depends on the number of fixed assets a company has. Thus, the construction and manufacturing sectors have a higher ratio than other industries.
Final Thoughts
Today’s financial markets are complex. No single metric can determine if your investment will be profitable or not. Therefore, you must improve your financial skills and learn the key metrics to analyze your investments. Using varied metrics will give a better idea of which company has the potential to offer the highest payouts. In addition, combining these metrics will provide you with a more comprehensive view of the company’s financials and earnings, helping you make more informed decisions.
