When it comes to picking the best stocks, there are dozens (maybe even hundreds) of different metrics investors use to analyze companies.
During our extensive research into finding the most profitable stocks, we’ve tested literally hundreds of different metrics and combinations to discover which are best.
Below, we’ve distilled the 10 most powerful metrics in investing.
There are certainly others that are variations on our favorite concepts below or are better suited for finding a highly specific type of stock (for example, the best small cap pharmaceutical stocks).
But, in general, we’ve found that a combination of the metrics below will help investors focus on some of the best stocks on the market.
We’ve grouped them into growth, value, and dividend-related metrics.
You can download a handout for future reference by clicking on the image below:
Let’s start with the four most powerful growth metrics.
1) Sales Growth
The best stocks tend to have solid, steady, positive sales growth.
They’re not necessarily the best or fastest growers on the market, but they’ve found a consistent formula for bringing valued products to many (new and existing) customers.
2) Earnings Growth
Similar to sales growth, we look for companies with positive earnings growth over time.
Because earnings is an accounting number, it can sometimes jump around a bit from quarter to quarter. That’s OK.
Overall, you want to find companies that are not only selling more (sales growth) but also keeping more (earnings growth).
Extra impressive are companies that are growing their earnings faster than their sales. This means they’ve both selling more and spending relatively less at the same time. That’s a powerful combination.
3) Free Cash Flow Growth
According to Investopedia:
“Free cash flow represents the cash a company generates after cash outflows to support operations and maintain its capital assets.”
Some people consider it the cash that’s available to shareholders after operating and investing in the business.
While net income and earnings per share can be manipulated or distorted by accounting practices (such as depreciation and amortization), free cash flow is a more honest view of how much money a company is really making.
Companies with steadily growing free cash flow are not only growing their business, but they’re generating lots of cash to invest, save, or return to shareholders.
4) Net Profit Margin
Profit margin is the ratio of a company’s bottom-line profit to its top-line sales. It measures how much of each dollar in sales the company keeps.
For healthy companies, this number should be consistently positive. Otherwise, they may have a business model that’s unsustainable. Put another way, if it costs a company $1.10 to produce just $1.00 in sales, that’s not a great business.
While net profit margin can fluctuate from quarter, over time it should be positive.
It can also be interesting to compare a company’s current net profit margin to its historical net profit margin.
A consistent upward trend in net profit margin is often a sign of good management and the possibility for expanding profits in the future.
That covers our four main growth metrics. Companies that score well across all four measures are strong performers that have a sustainable business model.
Now, let’s look at a few powerful valuation metrics.
5) Price / Free Cash Flow
This metric divides the price of a single share by the free cash flow per share (usually over the trailing 12 months).
Alternatively, it can be measured as market cap divided by total free cash flow (again, usually for the trailing 12 months).
They’re the same metric, one is just compared on a per share basis while the other looks at total company market cap vs. total free cash flow.
When this number is lower, it suggests the stock is undervalued.
Based on our extensive research, “Price / Free Cash Flow” is one of the most powerful valuation metrics for finding companies that are truly undervalued.
It allows you to focus on companies that are generating lots of cash relative to how investors are valuing their shares and screen out companies generating relatively little cash relative to how investors are valuing their shares.
As discussed above, because free cash flow provides such a transparent view of how much money a company keeps, comparing it to how investors are valuing the firm (market cap) provides an honest view of whether the stock is undervalued or overvalued.
6) Price / Sales
This metric divides the price of a single share by the sales per share (usually over the trailing 12 months).
Alternatively, it can be measured as market cap divided by total sales (again, usually for the trailing 12 months).
They’re the same metric, one is just compared on a per share basis while the other looks at total company market cap vs. total sales.
When this number is lower, it suggests the stock is undervalued.
Based on historical research, the price-to-sales ratio is another powerful metric to tell if a stock is undervalued or overvalued. That said, we’ve still found price / free cash flow to be the best.
Now that we’ve covered four growth metrics and two valuation metrics, let’s look closely at the three most important dividend metrics.
7) Dividend Yield
The dividend yield is the most important metric for dividend stocks because it tells you how much you’ll make in dividends each year vs. how much you’ll have to pay to buy a share.
In general, higher dividend yields offer more income. But it’s important to keep in mind the other two critical dividend metrics below.
Research has consistently shown that the highest dividend yields on the market aren’t necessarily the best stocks to buy.
8) Payout Ratio
Payout ratio measures how much a company is paying out in dividends vs. how much money the company made in earnings.
It’s essentially a measure of dividend sustainability because it examines whether a company is paying out too much in dividends compared to how much it’s making through its regular business operations.
Research suggests that companies with a high dividend yield AND low payout ratio are paying out a lot of money in dividends, but they can afford it because they’re making a lot of money from their core business. This is a sign of both long-term dividend sustainability and operating strength.
9) Dividend Growth
Research shows that companies that are steadily growing (or initiating for the first time) their dividend tend to perform well over time.
On the other hand, dividend non-payers and dividend cutters have performed the worst.
A growing dividend means a company is healthy, confident about its future, and committed to returning value to its shareholders.
So, in addition to dividend yield and payout ratio, it’s critical to analyze whether a company has a history of growing its dividend.
Finally, let’s look at one metrics that falls outside of growth, value, and dividends. It measures how stable a stock is:
Beta is a measure of how much a stock moves relative to its benchmark.
A beta of less than 1.0 indicates a stock is more stable than the market and a beta of greater than 1.0 shows the stock is less stable than the overall market.
In general, lower beta stocks tend to perform better than high beta stocks, especially during times of high market instability or economic uncertainty.
Put simply, beta seems to measure an element of stability, certainty, and confidence in a stock. Rather than whipping about, a low-beta stock tends to move in a more calm and controlled way.
Lesson Summary: The 10 Most Powerful Metrics in Investing
When it comes to finding profitable stocks, there are certain metrics that can help us eliminate poor performing, overvalued, and unstable companies while focusing in on the market’s top performers.
Here are the top 10 metrics we focus on when looking for stocks to buy:
- Sales growth
- Earnings growth
- Free cash flow growth
- Net profit margin
- Price / free cash flow
- Price / sales
- Dividend yield
- Payout ratio
- Dividend growth