Masters Series: Four Key Numbers I Look at Every Time I Evaluate a Business
Editor's note: Bought at the right time – and at the right price – any stock can turn into a huge winner.
But you have to know when a stock is cheap and when it's dear.
In today's Masters Series essay – originally published in Dr. David "Doc" Eifrig's Big Book of Retirement Secrets – he shares four simple metrics to look at before you buy any stock...
Four Key Numbers I Look at Every Time I Evaluate a Business
One of the best ways to build long-term wealth is by regularly investing in businesses.
Historically, stocks should return around 7%-9% a year. This is far above the average of inflation. So by saving money in stocks, you're almost guaranteed to increase your net worth over time. If you earn 8% and inflation is 3%, you're making "real" wealth... about 5% a year.
But it's vital for investors to know when to buy and sell individual securities. We start with four simple metrics when deciding to invest.
We look for relative values. So we're not just looking at the rock-solid, absolute numbers. We also want to look at those numbers relative to the market, the industry, and the security's own historical record.
Our four metrics are...
| 1. | Price-to-earnings (P/E) ratio |
| 2. | Price-to-book (P/B) ratio |
| 3. | Price-to-sales (P/S) ratio |
| 4. | Dividend (or interest) yield |
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Price-to-Earnings Ratio
The price-to-earnings (P/E) ratio is simply the stock's price per share divided by its earnings per share.
The P/E is often what you'll read about when professionals consider a stock. A low P/E often means you're getting a good price. A high P/E means the stock is expensive. I compare a company's current P/E with the market average, the stock's long-term average, and its competitors' averages.
Price-to-Book Ratio
The price-to-book (P/B) ratio is the stock's price per share divided by the book value per share.
Book value is determined by subtracting liabilities from total assets. Think of it as the corporate equivalent of a person's net worth. Divide that by the number of shares outstanding to get a book-value-per-share number.
The P/B is useful for valuing an asset. It gives you a realistic idea of the relative value of your investment dollar when considering another asset. If you buy at a P/B value of less than "one times book," you're getting a bargain. At 0.8 times book, you're buying assets for 80 cents on the dollar.
When the P/B is greater than 1, you're paying more than the "net worth" of the company's assets. That's not necessarily a bad deal. But if you start paying three to four times book value, you're entering dangerous and rarefied air. You're paying a lot for assets that may not be worth so much.
Price-to-Sales Ratio
The price-to-sales (P/S) ratio is a stock's share price divided by its sales per share.
This measures how much in sales you are buying for every $1 you spend on the stock. As with the P/E, I compare a company's P/S with its competitors' to see how it's valued relative to others in the same industry.
Dividend Yield
An investment that's generating cash and returning some of that cash to shareholders (in the form of a dividend) is what I call "shareholder friendly."
Companies with long histories of dividend payments top my list of potential investments. You can't use accounting schemes to fake a dividend for very long... So a solid dividend is often a sign of a great company.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
Editor's note: Doc's Big Book of Retirement Secrets is filled with wisdom and well-researched investment ideas. Longtime readers know Doc is one of the smartest and most accomplished people we've ever met. If you're interested in learning how to live a healthier and wealthier retirement, claim your copy right here.