If you are looking to build your retirement portfolio or just investing for passive income, then you are probably more likely to look for stocks that you can invest in for the long term. Sometimes it is difficult to locate just the right stocks. There are so many out there that it’s often easier to just go with what the popular topic is for the day on the investing network.
There are several investing ratios that you can use to get you to the portfolio that you’d like. Some ratios are better than others if you are investing for the long term.
How To Use Investing Ratios
Price to Earnings
The price to earnings ratio is great for current valuation and past valuation. However, if your investing time horizon is 5 to 10 years, the price to earnings ratio might cause you to be a little short sighted. Earnings forecasts typically do not go out 10 years, in fact the longest earnings estimate will probably only take you out to 5 years. Although this ratio is often used for valuation of the current price of a stock, it might not be the best for a long term investor.
Price to Book
The price to book ratio is a good one for comparing today’s price with the value of the company based on historical costs. The book value is measured using the historical cost or purchase price. Over time the stock price will change but the historical price will not. This is a good ratio to use for long term investing because you have the ability to track the ratio over time.
Price to Sales
The price to sales ratio is a ratio that is beneficial to use for companies that may see cyclical sales. Every company’s stock price is cyclical, whether it changes because of the business cycle or the industry cycle is the real question. If a stock exhibits substantial movement based on sales volatility, the price to sales ratio will be a good way to gauge if the stock is over priced. For the long term investor, you will want to look for a price to sales that is steady or growing. This shows that investors are confident about the continued sales growth.
Reinvesting Dividends for the Long Term
Retention Ratio and Payout Ratio
The retention ratio measures how much of earnings are being plowed back into the company. The payout ratio, conversely, measures how much of earnings are being paid out as dividends. You want to pay attention to the retention ratio for capital appreciation. If the company is retaining earnings and finding profitable ways to grow those profits into more earnings then your stock value should go up right? The payout ratio comes into play when you are interested in how much of earnings is needed to pay out the dividend. If a stock has a payout ratio of 45%, that means it uses 45 cents of every dollar to payout dividends, and that would make the retention ratio 55%. As a long term investor, you want a constant dividend, but you also want a chance at capital appreciation so the balance between the payout ratio and the retention ratio is pretty important to you. Make sure that you are reinvesting your dividends to get the benefit of compound growth.
Dividend Growth Ratio
If you’ve picked a dividend paying stock, then you will definitely want to pay attention to the dividend growth rate. The dividend growth rate is an estimate but it gives you an idea on the value of the stock for the future. If you are a long term investor and the annual dividend growth rate is an expected percentage you can determine the expected return of the stock by using today’s stock price. For example, a 5% growth rate for a dividend paying stock that has a price today of 20 dollars and a dividend of 2 dollars yields an expected annual return of 10.5%.
Do you pay attention to these ratios when investing for the long term?
This post was written by Latisha.
I do think it is important to have metrics to gauge investments performance. Too often, we assume that we’re on the right track only to find out years later that our strategy was seriously flawed. However, if you are periodly checking, you can prevent a big surprise at the end.
There is definitely a healthy balance to checking in on your investments without making the mistake of second guessing your original analysis. As long as you make it a point to keep in mind that you are investing with a long time horizon you won’t be scared by the temporary dips.
These ratios are the most critical metrics to use when picking stocks to invest in. They are the ones that I definitely check before deciding where to invest.
Once you have a system going, it does make it easier to pick the right stocks for your portfolio.
I definitely do check the ratios out before I pick out the stocks I choose. It is essential in order to choose successfully….or at least to the best of one’s knowledge.
Yeah because you can never be 100% about what is behind the numbers but if you dig into the financial statements you can have a better idea. Maybe that will be a future post 🙂
I highly recommend reinvesting dividends that’s where the real money is made. Great explanation on some aspects of fundamental analysis
I focus on price to tangible book value and P/E as ready metrics. I also like to look at the ratio of current assets to liabilities, cash positions, and free cash flow from operations. Good article, Latisha.
Thanks! Those are also good ones to check as well. Cash is king especially in this economy.
Thanks for posting this! I’m just starting to learn about investing, so it couldn’t have come at a better time.
Great! Let me know if I can answer any questions.
I’m more of a mutual fund investor. Thanks for these ratios as I am looking into stocks to expand my portfolio.
Mutual funds are an easy way to get started because you don’t have to do much research your self, but if you are looking to invest in individual stocks then you will definitely need a few ratios.
Or you can just look at what Warren Buffett is buying 🙂 Seriously though, I use most of your metrics, along with looking for “durable competitive advantage” (an original Buffett pearl of wisdom). Right now Berkshire Hathaway looks seriously undervalued.
Why follow when you can lead? 🙂
Competitive advantage gets into more of a fundamental style of analysis. It’s not quantifiable and a little subjective but when you’ve been doing it for as long as Warren Buffet you can probably handle some subjective decisions.
I should take these into consideration too when investing in my Divys, I rely mostly on the stock’s history and the consistency of their payouts and if they increase or decrease over time