Editor’s Note: One of the most commonly cited valuation metrics for stocks is the price-to-earnings (P/E) ratio. It is calculated by dividing the current stock price by earnings per share (EPS).

However, P/E is not meaningful in some cases. Let’s examine P/E and other useful but sometimes neglected valuation tools.

Look Beyond P/E

The EPS used in the P/E denominator is typically the EPS in the preceding four quarters (trailing P/E) or the expected EPS over the next four quarters (forward P/E). Of the two, I prefer the forward P/E because it is forward looking. Sometimes, analysts will look further down the road, and calculate the expected P/E ratio for, say, three years in the future.

But there’s a big caveat. Earnings can be misleading because items that aren’t necessarily a part of a company’s day-to-day operations can affect a company’s net income (e.g. depreciation, timing of revenue recognition, etc.). The end result is that the P/E ratio could provide a distorted picture.

Another reason is that for companies that do not generate an accounting profit. This could be because an established company had a down period, or it could be because the company is relatively new and hasn’t become profitable yet. When earnings is negative, the P/E ratio is negative. Since stock prices are never negative, clearly investors are using something else to value a stock.

Sales and Cash Flow

A substitute valuation metric is price to sales. This compares the price to revenue generated by the company. Since revenue is generally positive—a company would not exist anymore if sales are negative for any length of time—there’s essentially no chance for a negative ratio.

Two alternative valuation metrics are price to cash flow (P/CF) is price to free cash flow (P/FCF).

P/CF uses a company’s operating cash flow in the denominator. Operating cash flow is as the name implies. It’s the cash a company generates from its business operations. It does not count cash flow from investing and financing activities. It also omits non-cash items that affect earnings, such as depreciation.

If a company is generating consistently growing operating cash flow, even if earnings is low or negative at the moment, the company will likely become increasingly profitable in the future. A company that has lots of operating cash flow but low earnings may actually be in a very good situation because low earnings reduces taxes, but does not affect the ample amount of cash on hand.

If a company struggles to get positive operating cash flow, though, it’s a bad sign no matter what the earnings numbers look like. And if a company has good operating cash flow trends but net income isn’t showing signs of improving, then investors should analyze how the company is using its cash. Management could be recklessness deploying cash from operations, such as by wastefully investing in foolish projects.

Seeking Growing Free Cash Flow

P/FCF uses a company’s free cash flow, which is the cash flow left over after all expenses, interests, taxes, and dividend is paid. Basically, it is the net cash flow after all inflows and outflows have been accounted for.

A company that generates positive FCF is in good shape. At a minimum, this means that it doesn’t have to borrow money (debt) or issue new equity (dilutive secondary offering) to stay in operation.

More preferably, a company will generate growing FCF. Such a company can fund its own growth without outside capital (self-sustaining growth) and can also take shareholder-friendly actions such as repurchasing shares and paying dividend.

Of course, just having strong FCF trends doesn’t guarantee the company is a great investment, but it’s a good start. Investors should look at how the company is using the cash it’s generating. A good management team will find ways to optimize the use of cash, creating a virtuous circle and turning cash into even more cash.

The bottom line is that P/CF and P/FCF are metrics that serious investors should become familiar with. They reveal more about a company (and a stock) than the P/E ratio alone could and can help you find some stocks on the brink of taking off.

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