Being able to take things into context is important.
Many companies and investors love to throw around numbers that sound impressive, but it ultimately means nothing.
In other industries, it’s called vanity metrics. Not sure what it’s called in finance.
Let me give you an example of a vanity metric.
The average time a visitor spends at oldschoolvalue.com is two minutes 49 seconds compared to one minute for other sites.
This means OSV is performing better than the average site by 183%.
Impressed? Don’t be, because it means nothing.
A visitor could have stumbled upon this site, started clicking all sorts of things, gone for a coffee break, or simply waited for some big files to download.
Same concept with investing. Many companies boast about earnings growth, subscriber growth or improving operations, but these are just “power” words. Words meant to convey importance without much context or relevance.
Vanity Fundamentals and Investing RatiosPreviously, I wrote about why you need to learn accounting.
To summarize it briefly, it is the language of business. If you want to live in a foreign country, you must learn the language to be able to understand and interpret it.
Knowing the accounting concepts is like knowing the business vocabulary, but the important part is knowing how to interpret it.
Having a good understanding of accounting and how it all ties into business will help you avoid vanity fundamentals and investing.
But there are still fundamentals and ratios that
- mislead investors
- do not add value
- should not be used on their own
- EPS (Earnings Per Share)
- PE (Price to Earnings)
- PB (Price to Book)
- ROE (Return on Equity)
There is so much to earnings, but boiling it down to just a single value is overkill. The important factors have been eliminated and looking at earnings growth as a measuring stick for business growth is pure vanity.
Look at the following two companies.
- Company ABC and Company XYZ both achieved $100,000 in earnings from $1 million in revenue.
- Company ABC achieved revenues of $1 million and net income of $100,000.
- Company XYZ’s revenue came in at $800,000 with other income of $200,000 making up a total of $1 million revenue. Net income is also $100,000.
For this reason, when it comes to judging EPS, I always recommend the book Quality of Earnings. It goes into great detail of how to adjust the EPS to factor in changes due to tax rates, non-operating and non-recurring income.
Instead of taking EPS at face value, go beyond the vanity number and get to the core metric.
Look at earnings growth next to account receivables growth and inventory growth to see trends in the business.
You could do something like the format below to better gauge the business.
Owner earnings is an alternative to earnings you can use.
Vanity Metric #2: PE Ratio
On its own, the PE ratio is absolutely meaningless.
It is a relative measure, so it is only useful when you compare it to another PE ratio. In addition, it is difficult to figure out what a company is worth with just the PE ratio.
The best it can do is give you an approximation of whether the stock is cheap or expensive.
Somebody telling you that Netflix is a sell because it has a PE of 609 sounds smart, but it doesn’t answer questions such as what the fair PE is and why the PE is so high to begin with.
The PE ratio is just price divided by earnings per share and you just read what I thought on EPS. This is why PE is just as useless as a standalone investment ratio. It is the most misleading, misused and abused metric.
Instead, you could use something like the absolute PE valuation method. This method forces you to think about the different aspects of the business and growth to determine the fair value PE which you can then use to judge whether the stock is over or undervalued.
Or consider using alternatives like P/FCF or EV/EBITDA. Both are similar but offer more insight.
Vanity Metric #3: PB Ratio
Here is one more used by value investors but still often misused.
One thing is that Graham never spoke of finding just low PB stocks. He specified net-net stocks because he wanted companies trading at a low price to tangible assets.
Graham even took it one step further by looking for net-net working capital stocks where assets are of high quality and easily convertible to cash.
With that in mind, when looking at PB, it’s always best to eliminate intangibles and goodwill from the equation.
Unless you are dealing with a company where the brand sells itself like Coke, Pepsi and Windows, or necessary for business like Expedia (EXPE), most goodwill and intangibles are not as valuable as the company makes them out to be.
The best thing to do is remove it.
PB would then become price to tangible book which depicts a much clearer view of the company.
Vanity Metric #4: ROE
You may be surprised that ROE is on this list. If I wrote this one year ago, it wouldn’t be on here.
Although ROE is a very helpful measure, it can do better. By understanding the drivers behind ROE it goes from an average metric to a powerful one.
The best way is to use the DuPont analysis to break up ROE into five segments as shown below.
Via the five-step model, the interest burden is increasing, but the main culprit is a decline in operating margins.
By using ROE alone, you may have deduced that the company is just doing poorly, but by dissecting the vanity metric, you get to see that the core operation of the business is leading the drop in ROE.
Also consider using CROIC as well as ROE with the DuPont analysis.
Bringing it TogetherIt is very important that you don’t just accept data at face value. Take things in context. You invest to make money.
There is no need to start with a conclusion and then pick data to match your conclusion. I’ve only lost money that way.
One of the quickest ways is to find the metrics that you think are important and really ask yourself whether they add value to the overall investment.
If you saved a stock analysis and looked at it again 30 days later, are you confident that you would know why you saved it in the first place?
This is a problem I see with Wall Street analyst reports. I try to read them again a couple of months later and I have no idea what the report is trying to say because the numbers are filled with sales growth of 25%, earnings growth of 19% year over year. Impressive but fluffy duffy stuff.