Don’t Let These 3 Metrics Mislead You About Stocks

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You can use different metrics to get different information about a business and its finances. While every metric has its place in a company’s financial storytelling, some on their own can be a bit misleading and may not paint the full picture needed before making an informed investment decision. Here are three to watch out for.

1. Dividend yield

For stocks that pay dividends, the dividend yield is one of the most heralded metrics. The problem with the dividend yield alone, however, is that it fluctuates with the price of a stock. Companies set their annual dividends as a dollar amount spread over four quarterly installments. If a company’s annual dividend is $2 and its stock price is $100, the dividend yield is 2%. If the stock price falls to $50, the dividend yield is now 4%.

From the outside, a 4% dividend yield looks pretty lucrative, especially if you don’t know that the reason it’s so high is because the stock has fallen 50%. Something could have fundamentally changed with the company now making it a bad investment, but if you just looked at the dividend yield without knowing (or considering) it, you could be putting yourself in a position to lose money.

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2. Price/earnings ratio (P/E)

The primary goal of a value-investing person is to find companies whose stock price is trading below their intrinsic value. A metric that many value investors rely on is the P/E ratio, which is obtained by dividing a company’s stock price by its earnings per share. The higher the P/E ratio, the more investors pay for every dollar of a company’s earnings. For this reason, it is often used to determine whether a stock is undervalued or overvalued.

The P/E ratio is a good metric for finding undervalued stocks, but looking at it by itself is misleading. To really understand if a stock is undervalued, you need to compare its P/E ratio to similar companies in its industry. Some industries have higher P/E ratios across the board than others, so this would be an apples to oranges comparison.

For example, it’s common for construction companies to have P/E ratios in the 30s, but it would be odd (and a deal breaker for most investors) to see a bank that high. You wouldn’t compare Vulcan Materials (MVC -0.22%) at JPMorgan Chase (JPM -0.49%).

3. Net profit

A company’s net profit is the money that remains over a period of time after paying operating expenses, cost of goods sold, taxes and interest. Generally, the higher a company’s net profit, the better, but sometimes this figure can be inflated due to one-time events that do not paint a true picture of a company’s normal operations.

For example, the Australian company Mirvac (MGR 0.96%) increased its net income from $447 million to just over $1 billion (69%) in 2016, but that was almost entirely due to the rise in value of its real estate investment portfolio; its operating profit rose only 6%.

When looking at a company’s profits, it is best to look at net profit and operating profit, as this gives a more complete picture. Each is important on its own, but they are best used together.

JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Stefon Walters has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.

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