5 Must-Know Fundamental Analysis Metrics for Smart Stock Picking
Introduction
In the world of investing, fundamental analysis is often considered a cornerstone in the process of identifying stocks with strong long-term upside potential. Fundamental analysis attempts to uncover important ‘factors’ that accurately reflect a company’s financial health, profitability and growth prospects. In comparison, Technical analysis focuses on price trends or trading activity and tends to pay little attention to the actual underlying business. We believe that investors aiming to make informed decisions should have a robust set of key metrics that they review and maintain for their holdings and opportunity set. Below, we offer five must-know fundamental analysis metrics to elevate your stock-picking strategy.
1. Price-to-Earnings (P/E) Ratio
What It Is: The P/E ratio compares a company’s stock price to its earnings per share (EPS).
Formula: P/E Ratio = Stock Price ÷ Earnings Per Share (EPS)
Why It Matters: This metric helps gauge if a stock is overvalued or undervalued relative to its earnings. A high P/E may signal growth expectations (we’d call this “expensive”), while a low P/E could indicate a stock is undervalued (we’d call this “discounted” or “inexpensive”). While the P/E ratio often looks backwards to the trailing twelve months, we also employ forward P/E ratios in our analytical work, which uses today’s current price with analyst consensus expectations for the next twelve months (or beyond) of earnings.
2. Price-to-Book (P/B) Ratio
What It Is: The P/B ratio measures market value against book value, essentially revealing a company’s net asset value.
Formula: P/B Ratio = Market Price per Share ÷ Book Value per Share
Why It Matters: This metric can be considered particularly useful for companies in asset-heavy sectors (e.g., banking, real estate). A P/B below 1 suggests the stock trades below its book value, potentially signaling a bargain.
3. Debt-to-Equity (Debt/Equity) Ratio
What It Is: This ratio evaluates a company’s financial leverage by comparing total liabilities to shareholders’ equity.
Formula: D/E Ratio = Total Liabilities ÷ Shareholders’ Equity
Why It Matters: A high D/E ratio indicates reliance on debt, increasing bankruptcy risk. However, industries like utilities often carry higher debt. Always benchmark against sector peers.
4. Return on Equity (ROE) and Return on Capital Employed (ROCE)
What It Is: ROE measures profitability relative to shareholders’ equity. ROCE is similar, but considers all capital sources, including debt and equity.
Formula: ROE = Net Income ÷ Shareholders’ Equity | ROCE = Net Income ÷ (Shareholders’ Equity + Debt)
Why It Matters: Rising ROE and ROCE metrics suggests efficient capital use. For example, a ROE or ROCE of 15% means the company generates $0.15 for every dollar of equity (or capital employed). Empirical evidence suggests that companies with higher ROE and/or ROCE have experienced better long-term performance.
5. Free Cash Flow (FCF)
What It Is: FCF represents cash left after operating expenses and capital expenditures.
Formula: FCF = Operating Cash Flow − Capital Expenditures
Why It Matters: Positive FCF enables reinvestment, dividends and/or debt reduction. A company with growing free cash flow is better positioned to innovate and weather downturns.
Conclusion: Combine Metrics for Smarter Decisions
No single metric works all the time, but combining these five metrics can often provide a better overview of company’s health, financial stability and growth potential. Consider pairing quantitative comparisons with qualitative factors (management quality, industry trends). Remember—patience and consistency are key to long-term investing.
We offer these five metrics in addition to several others in our Target Prices, which are published twice per month for all of our 100+ currently recommended stocks. Happy investing!
Kovitz Investment Group Partners, LLC (“Kovitz”) is an investment adviser registered with the Securities and Exchange Commission. This report should only be considered as a tool in any investment decision and should not be used by itself to make investment decisions. Opinions expressed are only our current opinions or our opinions on the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.