When investors are selecting a stock, they must have adequate information to make the right decisions. There are more than, 10,000 US stocks that an investor can choose from hence an investor must have the right metrics to compare different stocks. It is important to know the important valuation metric (or several) to evaluate the equities.

Get The Full Seth Klarman Series in PDF

Get the entire 10-part series on Seth Klarman in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

We respect your email privacy

Also see

Important valuation metric
OpenClipart-Vectors / Pixabay

On the important valuation metric list is the dividend yield. The advantage of the dividend yield is that it indicates the amount of money you can expect to get from an investment. For instance, if you invest $500 in the stock of a company and the dividend yield is 5% you expect to get $25 in the next year. However, this metric is only a good metric for an investor who is looking to make a short term investor. A short-term investor will only be concerned about the investment they will get in a nutshell period. Conversely, a long-term investor will be interested in the future performance of a company, and if they use the dividend yield, they will not make the right choice of stock. Long-term investors should avoid using the dividend yield as a metric evaluation.

The second important valuation metric is the dividend growth: This is the most appropriate metric evaluation for long-term investors. A stock can indicate that it has a high stock yield, but it has not been consistently performing well. This type of stock may have a history of being volatile and may not be appropriate. Alternatively, some stock can indicate constant yield, but because of inflation, the returns will be minimal. It is important to consider the history of the stock and learn how the stock changes over time. Considering the past pattern of the company will give you a clear picture of the performance of the stock and this trend is likely to continue.

The third metric evaluation is payout ratio. The payout ratio is a good measure for long-term investors. It indicates the amount of dividend that is paid to investors every year. A good company has a low payout ratio. A low payout ratio means that the company is investing a significant proportion of its profits in the growth of the business. It indicates that the firm is retaining more profits which can be accumulated to make the significant future investment.

The fourth  important valuation metric is the EBITDA/EV is a reliable metric evaluation. It compares the enterprise value of a company to profits before interest, taxes, depreciation, and amortization. The EBITDA/EV considers the debts and liabilities of a company to the earnings of the enterprise. It is a useful metric when an investor wants to find out the value of the business.

The fifth important valuation metric is the return on assets. The return is a good metric measure because it indicates the level of which the management is using the assets of the company to generate earnings. A business that is performing well will have a high return on assets. For instance, a return on assets of 30% indicates that the company is efficiently using assets to generate earnings.

The sixth important valuation metric is the operating margin. The operating margin shows the amount of revenue that a company retains after handling overhead and operational costs. Operating margin indicates the efficiency of management in managing costs. When an investor is using the operating margin to assess stock of a company they should look at the trend of the enterprise.

Therefore, the investor should compare the operating margin with records of the company. The operating margin can also be useful if an investor is torn between two different stocks. The investor can compare the operating margin of a company with that of another company to determine the stock that will be a sound investment. A high operating margin indicates that a company is retaining high revenues after catering for its operational cost hence the investor can choose the company with a higher operating margin.

The current ratio is an important valuation metric. The current ratio is a liquidity ratio that indicates the ability of a business to cater for its short-term liabilities. A business that is performing well must have the capacity to provide for its short-term obligations. Small businesses are encouraged to maintain a current ratio of assets to liabilities of 2:1. Small businesses have high chances of getting bankrupt if they do not control their cash well.

Maintaining a high current ratio is good. Large companies, on the other hand, have an advantage of maintaining a lower current ratio. Big companies already have a sound financial base and generate cash from financing activities and revenues. The companies can use their money in long-term investment instead of holding the money. As a result, they can maintain a lower current ratio and still face minimal liquidity risk.

The last metric evaluation that most investors do not concentrate on is the operating cash flow. This metric can be found in the statement of cash flow. The cash flow is an important financial statement that is sometimes overlooked by investors. You must utilize the cash flow to know how precisely a company increased its finances. Did it raise money through selling stock, taking loans and selling a business? A good business will mainly raise capital through its revenues and operating activities.

Important valuation metric - Not just numbers

Investors look at various metric to know how sound a company is. Investors must be careful when making decisions on businesses to invest in the financial crisis was a wakeup call for investors. The financial crisis led to the establishment of laws that require businesses to be transparent. As a result, investors have a broad range of information that is disclosed. Investors should use a combination of the metric valuation before making any investment decision.

Different financial reports represent a different set of information. Using a set of metric valuation will ensure that investor makes a sound decision. A single metric valuation method can have a particular weakness and fail to reflect some important financial information. To be on the safe side investors should use a combination of metrics.