Fundamental Analysis
Key Stock Metrics: What Each One Measures and Hides
Roughly a dozen figures account for most of what matters about a company, and knowing what each one omits proves more useful than knowing how it is calculated.
Forty metrics are unnecessary. Twelve cover most of what matters, and knowing what each one omits proves rather more useful than knowing the formula behind it, since the formula is printed everywhere and the omissions are printed nowhere.
The grouping below follows the question each figure answers, with a note on how each can be dressed up.
Valuation: what are you paying?
P/E ratio = price ÷ earnings per share. What you pay for a dollar of current profit.
The weakness sits in the denominator. Earnings arrive at the end of a long chain of accounting choices, and the multiple inherits every one of them, which is why a low P/E most often means the market expects earnings to fall and is frequently right about that, which makes the cheap multiple a warning rather more often than it makes a bargain.
Forward P/E uses estimated future earnings. More relevant in principle. The analyst estimates it depends on are systematically optimistic.
EV/EBITDA = enterprise value ÷ earnings before interest, tax, depreciation and amortisation. Because enterprise value includes debt, this handles companies carrying different debt loads better than the P/E does. Work it out with the market cap calculator.
P/B ratio = price ÷ book value, useful for banks and asset-heavy businesses and close to meaningless for software companies whose main assets never appear on the balance sheet at all.
PEG ratio = P/E ÷ earnings growth rate, an attempt at pricing growth that is sensitive to the growth rate chosen and trivially gamed by picking a flattering period of history.
Profitability: is the business any good?
Gross margin = (revenue − cost of goods) ÷ revenue. That is pricing power. Watch the trend, because a margin falling two points a year describes a competitive position eroding whatever the level happens to be.
Operating margin = operating income ÷ revenue. Profitability after the business has been run, before financing and tax. The cleanest single measure of operating efficiency.
ROIC = net operating profit after tax ÷ invested capital. I regard it as the best summary of business quality available, because it tells you what growth is worth.
Consider two companies. One earns 20% on invested capital and creates value every time it reinvests a dollar, while the other earns 4% against an 8% cost of capital, destroys value by growing, and would serve its owners better by standing entirely still.
| ROIC | Reading |
|---|---|
| Above 20% | Strong competitive position; growth compounds value |
| 10–20% | Solid |
| 5–10% | Marginal once cost of capital is deducted |
| Below cost of capital | Growth destroys value |
Cash: is the profit real?
Operating cash flow is the cash a business generates before capital spending.
Free cash flow = operating cash flow − capital expenditure. Cash genuinely available to pay dividends, buy back shares, reduce debt or reinvest.
Trust this number. Earnings can be shaped by judgement, while cash arriving in a bank account largely cannot.
The most useful check in fundamental analysis, to my mind, is the comparison of net income with operating cash flow across three to five years, since the two ought to track roughly together. Profits rising while operating cash flow stagnates mean something in the accounting is doing work the business is not: aggressive revenue recognition, ballooning receivables, or inventory piling up unsold.
Balance sheet: can it survive a bad year?
Debt-to-EBITDA. Under 3× is generally comfortable, and above 4× leaves very little room when earnings fall or rates rise.
Interest coverage = EBIT ÷ interest expense. Below 3× a modest earnings decline begins to threaten the ability to service debt.
Current ratio = current assets ÷ current liabilities. Near-term liquidity, and anything below 1.0 deserves investigation.
Debt is the thing that turns a difficult year into a terminal one, because a business carrying none of it survives almost any downturn, whereas the same business at 5× leverage may fail to survive a mild one.
Per-share figures, and why buybacks flatter them
EPS = net income ÷ shares outstanding. The most quoted number in markets, and among the easiest to move without improving anything underneath it.
Buy back 10% of the shares and EPS rises roughly 11% on flat net income, which is the same profit divided among fewer slices, so always check whether net income grew alongside EPS.
Dilution is the mirror problem. A company issuing shares to fund itself or to pay employees raises the count, so EPS can fall while the business underneath it improves.
A ten-minute screen
- Free cash flow positive and tracking net income across five years
- ROIC above 10%, ideally stable or rising
- Gross margin stable or improving, since falling margins signal erosion
- Debt/EBITDA below 3×
- Share count flat or falling, with net income growth explaining the EPS growth
- Valuation in context against its own history and its peers
Passing all six does not make a company a buy, and failing one test does not disqualify it. The screen exists to surface the questions worth asking, and the answers still have to be found in the filings, in the competitors and in the industry itself.
Next: value traps and falling knives for what happens when cheap keeps getting cheaper, and insider buying vs selling for the one disclosure with genuine predictive content.
Frequently asked questions
What are the most important metrics in stock analysis?
Free cash flow, return on invested capital, the direction of the operating margin and the debt-to-EBITDA ratio will cover most of what matters for most companies. Taken together they answer four questions: whether the business generates real cash, whether it earns a decent return on the money it puts to work, whether its economics are improving or decaying, and whether it can survive a bad year without going to the market for help.
What is a good P/E ratio?
There is no universal figure, and the search for one is probably the most common mistake in fundamental analysis. A P/E of 12 can be expensive for a business whose earnings are declining, while 35 can be cheap for one compounding at 40% a year. The multiple only carries information when you read it against the company's own history, its direct competitors, and the growth it is actually expected to deliver.
Why is free cash flow better than earnings?
Earnings rest on accounting judgements about revenue recognition, depreciation and provisions, each of which leaves management a good deal of latitude. Free cash flow measures the cash a business generates after capital spending, and that is much harder to dress up. Where profits keep being reported without matching cash flow, you are looking at one of the more dependable warning signs in fundamental analysis.
What does ROIC tell you?
Return on invested capital measures how much profit a company earns on the money tied up in the business. A firm earning 20% on invested capital creates value every time it reinvests a pound. One earning 4% against an 8% cost of capital destroys value by growing, which is a genuinely counterintuitive result and one that most people resist on first hearing. As a single summary of business quality, I have not found anything better.
Which metrics are easiest for management to manipulate?
Earnings per share, adjusted EBITDA, and more or less any figure carrying the word adjusted or the label non-GAAP. Buybacks lift earnings per share without the underlying business improving at all, and adjusted metrics have a habit of excluding costs that recur every single year. Operating cash flow and free cash flow are meaningfully harder to influence, which is much of the reason to prefer them.