Even those who have no interest in stocks or investing have some vague sense of what stocks are—a piece of ownership in a company that, in theory, gets you a piece of ownership in the company’s earnings. It stands to reason from this basic premise, then, that the value of that stock should correspond to that company’s earnings. This is why the price-to-earnings ratio is so popular, and why the earnings per share metric is one of the most prominent in security analysis.
However, its popularity undermines its undoing. The PE ratio was enough grounds for investing many decades ago, but its ease of calculation and simplicity mean that it has become more of a baseline to start analysis than anything else. Different metrics have been sought, such as price-to-earnings growth, price-to-enterprise-value, and even price-to-sales. These weren’t developed simply to give investors an edge in finding a better way to measure stock prices; they were also developed to give different perspectives on a company.
Much like the parable of the blind men and the elephant, these different metrics serve to give different perspectives on a very large and hard-to-comprehend entity: a firm. And while analysts aren’t expected to know all of them, and definitely aren’t expected to remember the formulas behind all of them, analysts are expected to be familiar with the idea that different metrics are important in different contexts, with some rising to become industry standards superseding PE ratios.
While an analyst doesn’t need to memorize these concepts, a quick introduction to some and why they’re used is helpful for understanding why they exist at all—and which ones an analyst may need to look for in future research.
Value versus Growth Stocks
In the world of equities, the PE ratio remains an important starting point for a conversation, but it is never the ending point.
For value stocks, there are other very important metrics, such as price-to-free-cash-flow, which analyzes how much investors are paying for the cash that companies can produce, or even price-to-earnings-growth, because 10x earnings that grow 5% a year are not likely to be as valuable as 100x earnings that grow 70% a year.
That brings us to the issue of growth stocks, in which earnings may be light or nonexistent, but extremely fast growth into a new market (or displacing an old player in an old one) suggests that a firm can grow its size to the point where it can become significantly profitable. In this scenario, revenue is what is important, so things like revenue growth rates, price-to-sales, and other focuses on the top line become much more important (and in some cases the only important metrics) than earnings.
The Tech Indicators
Growth stocks can be a challenge, though, because of their low profitability, which encourages sector-specific metrics to enter the conversation. In tech, the largest vertical in the world of growth stocks, a common metric is annual revenue per user (ARPU) or gross merchandise value (GMV). Here one is looking at the potential value of users of a platform to extrapolate future earnings potential, and since there are a lot of variables and time between those two things, this analysis can easily be influenced by exogenous and unpredictable factors. The analyst, therefore, has to be diligent and constantly keeping her analysis and inputs fresh.
REITs: FFO and AFFO
Real estate focuses on yield like bonds but is an owned asset like stocks, making it a bit of an odd duck for analysts. Many specialize in real estate and don’t venture elsewhere, while many others become specialists in other asset classes while avoiding real estate.
This makes sense, as real estate has many metrics that other pockets of financial services don’t think of—things like cap rates and occupancy rates. Others, like cost of capital and revenue, are more familiar. But two of the most important and hardest to understand are unique to REITs: FFO and AFFO.
REITs are, like any other company, a legal entity that owners have fractional interests in; publicly traded REITs then sell shares of themselves on the open market. But because these valuations are underpinned by real estate, metrics like EPS are meaningless. Instead, funds from operations (FFO), and the non-GAAP adjusted Funds from Operations (AFFO) are preferred. These incorporate many peculiarities of real estate (like amortization and depreciation, which on an EPS basis makes earnings look bad despite both being positive for real estate businesses) to give a more accurate picture.
Coupons, Yield to Worst, and Other Bond Terms
Bonds deserve an entire book on their own unique metrics—and in fact, there are many written on the topic. Bond investing is more quantitative than stock investing and reliant more on statistical analysis of the past than on anything else. For this reason, some simple snapshots derived entirely from math, things like coupon rates and yield to worst, are important, and they are metrics that debt analysts have in their back pockets at all times, even if equity researchers never think about them.