This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
Unless your portfolio consists only of energy companies, if you look at the 2022 performance of your stocks, the majority are likely down. Since the start of the year, the three major indexes -- S&P 500, Nasdaq Composite, and Dow Jones -- are down over 23%, 32%, and 16%, respectively (as of October 20).
On one end, bear markets and down periods can present great opportunities for those with time on their side. On the other end, the drop in prices can present a lot of value traps. A value trap is a stock trading at a low price that looks like a good deal but is a bad investment. That's why it's important not to take a stock's value at face value. Instead, use these metrics.
Price-to-earnings ratio
As an investor, the sooner you learn that cheap isn't always a good value, the better. A $500 stock could be undervalued, and a $5 stock overpriced. For example, if a penny stock were priced at $5, it would be considered absurdly high by almost all standards. However, if a stock like Booking Holdings were priced at $500 instead of its current price around $1,775, it might be the deal of the century right now.
You don't want to buy lots of shares because they're "cheap," only to be investing in a failing business. Instead of looking at price alone, investors can use the price-to-earnings (P/E) ratio to help determine whether a stock is undervalued or overvalued. You can find a company's P/E ratio by dividing its current stock price by its earnings per share (EPS). A company's P/E ratio tells you how much you're paying for each $1 of its earnings.
To determine a stock's value, you can't look at its P/E ratio by itself; you need to compare it to similar companies in its industry. Some industries have naturally low P/E ratios (like banking), and some have naturally high P/E ratios (like biotechnology). So it can be misleading to compare companies across industries. If you compare similar companies and notice a company's P/E ratio is lower than the others, it could mean it's undervalued and vice versa.
Payout ratio
When a company declares its dividend for the year, it does so as a dollar amount per share. Because of this, a stock's dividend yield -- found by dividing its yearly dividend by its current stock price -- can often fluctuate. For example, if a company's yearly dividend is $2 and its stock price is $100, its dividend yield would be 2%. If the stock price dropped to $50, the dividend yield would be 4%.
With prices dropping, dividend yields are naturally increasing, leading to dividend traps. A dividend trap is a company with a too-good-to-be-true dividend yield that's unsustainable and likely doesn't warrant the investment.
Instead of just looking at a company's dividend yield, you should look at its payout ratio, which lets you know how much of its earnings it's paying out in dividends. You can find the payout ratio by dividing a company's yearly dividend by its EPS. Generally, you can find these numbers on your brokerage platform (the easier route) or within a company's financial statements.
If a company's payout ratio is more than 100%, it's paying out more than it's bringing in. Which, needless to say, isn't a good thing. A "good" payout ratio is also relative to the industry, but between roughly 30% and 50% is a good starting point. Too low, and it's not quite as shareholder-friendly. Too high, and it could mean it's unsustainable or a company isn't reinvesting enough back into the business.
Use this time to your advantage
With many companies trading at low prices we haven't seen in quite some time, now could be a chance for investors to go discount shopping and grab shares of some great companies. However, it's still important to focus on the fundamentals and not be lured in by low prices or high dividend yields. A low price doesn't mean much if the price goes lower, and a high dividend yield doesn't mean much if you lose way more in value than you earn in payouts.
A couple of extra steps can go a long way.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
