Which valuation metrics matter most when picking ASX shares?

There are many ways to measure a company's worth. So how do you choose the best ones when determining which stocks to buy?

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There are many ways to measure the performance of a business to analyse whether its ASX shares are worth investing in.

On the "positive" side there are metrics like earnings, revenue, and profit. Then you have to balance those with the negative measures like expenses and liabilities.

But what are the most important numbers to look at?

To answer this, US financial expert and buy-and-hold advocate Brian Feroldi presented two stocks and asked his newsletter readers to choose one to buy.

Would you choose to buy A or B?

Feroldi said that stock A represents a business that has seen its:

The company behind stock B is performing like this:

  • Revenue rise 320% since 2019
  • Operating margins expanded 14 percentage points since 2019
  • Price-to-free-cash-flow ratio is 35

Which of these shares would you invest in?

"We hope the answer is obvious. Stock B would definitely win our money," said Feroldi.

"Torrid revenue growth means people love what's offered. Expanding operating margins suggests there's a moat present and operating leverage is kicking in. And the valuation — while not cheap — looks reasonable given the top-line growth."

He then revealed that stock B is actually a real company. It's e-commerce giant MercadoLibre Inc (NASDAQ: MELI).

With the share price rocketing more than 1,200% over the past 10 years, MercadoLibre is a top portfolio holding for Feroldi and his newsletter colleagues Brian Stoffel and Brian Withers.

Context matters when analysing metrics

But there's a catch to the choice between the two stocks.

It's that stock A is also MercadoLibre.

Feroldi explained that expenses are up because the MercadoEnvios fulfilment business "costs a lot to build out". Gross margin is down because the payment arm MarcadoPago is a business driven on volumes rather than fat margins.

"The PE ratio currently looks 'insane' mostly because of the accounting differences between earnings and free cash flow."

This is why choosing metrics to pay attention to when selecting ASX shares to buy is so tricky.

Feroldi suggested investors remember one critical thing when evaluating numbers measuring business performance: context.

"Context matters. We know this to be true in our non-investing lives, but often forget it when it comes to investing," he said.

"Valuation is part art and part science. If you choose to invest in individual stocks, you need to understand which valuation metrics matter, when they matter, and when they should be ignored."

Motley Fool contributor Tony Yoo has positions in MercadoLibre. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended MercadoLibre. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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