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Top 3 Useless Stock Metrics that Investors Use

September 25, 2013


Useless Stock Metrics Only Make You Lose Money

There are metrics used in stock analysis that are useless and largely uninformative.

In spite of this, many of these are popular and they shouldn’t be popular. (Granted, I think “pop” music shouldn’t be popular so what do I know?)

Some of this will be an extension of a conversation in the OSV Stocks Forum

So without further ado . . .

Useless Stock Metric #1: Price to Sales (P/S)

Price to sales is one of the most useless metrics that is quoted for stocks. It’s both looked at on the individual stock level but also looked at, occasionally, for the entire stock market (say the S&P 500).

There are at least two things wrong with this metric.

Problem 1

The first has to do with leverage.

I’m going to use an example (which we’ll come back to when looking at the other metrics) of a rental property.

Imagine you have a house that’s selling for $100. It has the capacity to earn $12 in rent and there are annual expenses (taxes, maintenance, etc) of about $6 for Net Operating Income (NOI) of $12 – $6 = $6 .

Now consider two scenarios.

First, let’s suppose you pay cash for the house. What will the price to sales (P/S) ratio be?

The “price” in this case is the value of the equity which happens to be $100. The “sales” is the rent that’s earned from the property which is $12.

This gives a P/S:

sm1.png

So far so good.

But now consider another alternative which I think is more common.

Let’s suppose that we use some leverage by putting 20% down and taking out a mortgage for the other 80%.

Revenue doesn’t change at all; it’s still the same $12. What’s different is the equity which is now only $20. This gives us:

sm2.png

The levered house actually looks “cheaper” on the basis of price to sales. This doesn’t indicate that it’s really cheaper of course. It just an indication that it’s a lousy metric.

The problem with sales or rent or revenue, is that it’s not only produced by the equity assets. All of the assets (in our example, the whole house) are required to produce that revenue (rent). So comparing the revenue to the equity which is just one slice of the assets is a bad comparison.

A better comparison (and this can be seen from Prof Damodaran’s table) is Enterprise Value to Revenue.

Problem 2

The second problem P/S is well stated by James Montier from his book Value Investing: Tools and Techniques for Intelligent Investment.

(You can find the relevant chapter online as a standalone article here.)

Here’s one relevant issue:

Price-to-sales has always been one of my least favourite valuation measures as it ignores profitability. Reductio ad absurdum demonstrates this clearly. Imagine I set up a business selling £20 notes for £19, strangely enough I will never make any money, my volume may well be enormous, but it will always be profitless. But I won’t care as long as the market values me on price-to-sales.
So I think that’s another reason to consider this metric to be problematic. Montier does suggest it can be used to identify overvalued companies since a company’s profits will ultimately be constrained by the amount it sells.

Verdict on P/S

Avoid this one altogether. Exception may be to identify overvalued firms.

Use Enterprise Value to Sales instead as this makes a much better comparison. All of the assets, whether financed solely by equity or some combination of equity and debt, contribute to the sales of the firm.

Useless Stock Metric #2: Return on Assets (ROA)

This is a fairly popular metric and I think it should be. After all, return on assets (ROA) is an attempt to measure the productivity of the firm’s assets.

What’s not to like?

The problem is the way that ROA is typically defined.

Return on assets is typically defined as follows:

sm3.png

The problem is the numerator.

Net Income (also known as “earnings”) tells you how much profit the equity owners earned. We get a similar problem with leverage like we did with P/S.

Let’s go back to our house example.

In the case of the house, the total assets will be the value of the house: $100.

But what’s “net income”?

Net income is actually not a good comparison with Net Operating Income (NOI) since NOI does not subtract out interest or taxes whereas net income does. NOI is more akin to Earnings Before Income and Taxes (EBIT).

For simplicity, let’s ignore taxes (assume taxes are 0%). What’s the net income going to be?

Well, it’s going to depend on whether or not we took out a mortgage to finance the house. Let’s consider the two scenarios we did above.

Scenario 1

In the first case we bought the entire house with cash. Since there will be no interest (and we’re ignoring taxes), earnings will be NOI.

In this case ROA will be:

sm4.png

Scenario 2

In the second scenario we assumed 20% down on the house and 80% for the mortgage. Let’s assume the mortgage interest comes out to 4%.

Total interest expense will be 4% x $80 = $3.20.

As a result, this is what ROA will be in the levered case:

sm5.png

From this we can conclude that the unlevered house is more productive than the levered house in spite of the fact that it’s the same house!

Why would financing the house with some debt result in an asset becoming less productive?

Verdict on ROA

ROA as it’s commonly defined needs to go in the waste bin. But seeing how productive a company’s assets are is a very reasonable piece of information to know.

As a result, I’m suggesting a few alternative ways to define it:

sm6-300x217.png

I’m not sure which one is better. But I do know that each of these does a better job of showing how productive the assets are regardless of how they were financed.

Let me know what you think about this one.

Useless Stock Metric #3: Enterprise Value to Free Cash Flow (EV/FCF)

Occasionally I see people use one of two enterprise value metrics that are useless.

  1. Enterprise Value to Free Cash Flow (EV/FCF)
  2. Enterprise Value to Cash Flow from Operations (EV/CFO)
Enterprise Value represents the total (unlevered) value of all the operating assets. Non-operating assets are any assets that aren’t needed for the basic operations of the business.

For example, stocks and bonds owned by a manufacturer are not needed for the operations of a business but they are still part of the total value. (On the other hand, stocks and bonds owned by an insurance company are very much part of their operating assets.)

Enterprise value is a very useful metric to look at. The problem is that, like the two ratios before, it’s a bad comparison.

Take a closer look.

The way Cash Flow from Operations is calculated is by starting with net income (equity earnings) whichdoesn’t include interest paid to debt holders. Then various non-cash related expenses and revenues are backed out of that calculation.

As a result, CFO (as it’s frequently calculated) is a reflection of cash flows available to equity holders provided we ignore capital expenditures.

There is no clear standard on how Free Cash Flow is to be measured.

In fact, depending upon which definition you use, my criticism may not be appropriate. I personally like to consider Free Cash Flow to be an equity figure. So it’s similar to CFO except we deduct for various capital expenditures from it. I then like to use the term Free Cash Flow to the Firm (FCFF) to refer to the cash flows generated by the firm so there’s a distinction.

Some calculations of FCF include interest while others do not. The fact that the term is not well agreed upon leads to people using it incorrectly.

This could be fixed if US accounting standards treated interest as a financing activity. After all, dividends, stock issuance and buyback, and debt issuance and buyback are all financing activities. Interest is not technically an expense but a payment to one of the owners of the business.

But I’m not going to be changing accounting standards any time soon.

Verdict on EV/FCF and EV/CFO

This depends on how the terms are defined.

If they are defined as equity figures, where the interest is subtracted out, then these metrics have the same problems that P/S and ROA have in that they are comparing equity cash flows to the total value of the operating assets (which includes debt, equity and preferred equity).

The result will be that firms that have debt will appear more expensive than they actually are.

On the other hand, if CFO and FCF, or as I like to call it, FCFF, include interest paid to bondholders then these metrics make for useful comparisons.

It’s important that the terms get clearly defined and then get matched with the appropriate valuation metric.

EV/CFO(equity) and EV/FCF(equity) are useless metrics.

EV/CFO(firm) and EV/FCFF can be useful metrics for valuation.

Conclusion

All of the above metrics involve making inappropriate comparisons. While it’s OK to compare, say, debt to assets if you want to measure the amount of leverage used, it doesn’t make sense to look at one income or cash flow metric and then compare that to an unrelated asset or value metric.

Let’s get rid of some of these useless metrics and replace them with more appropriate ones.

Do you have any?

About the author:

Jae Jun
Founder of Old School Value (http://www.oldschoolvalue.com) dedicated to offering the most complete and detailed stock valuation and analysis spreadsheet. Investing made easy by importing 10 years of financials and 5 quarterly statements directly to excel for your analysis needs. Save time, make smarter decisions and make more money.

Visit Jae Jun's Website


Rating: 3.1/5 (12 votes)

Comments

batbeer2
Batbeer2 premium member - 9 months ago
Thanks for an interesting and well presented article.

In general: attempting to find a superior formula that calculates a metric that works under more general conditions, will make you a great scientist and a terrible investor. If you assume investing is an art, learning how to apply the different metrics in the right context is the key.

Specifically: >> The levered house actually looks “cheaper” on the basis of price to sales. This doesn’t indicate that it’s really cheaper of course. It just an indication that it’s a lousy metric.

No. Value is what you get, price is what you pay!

In the example of the house, you ignore the impact of interest rates. If the interest on a mortgage is much less than the rental income, the house with the mortgage is in fact much cheaper. At the end of the day, the owner of the house with a mortgage at very low interest rates gets the same utility as the renter but at a much lower cost.

>> Use Enterprise Value to Sales instead as this makes a much better comparison.

If you know what P/S is, and what its limitations are, use it. If you don't, don't. If that's the case, you probably don't understand the alternatives either. They are more complex. EV adds debt (the value of which is tied to interest rates) to equity and the resulting number is something I for one don't understand. It has no meaning in the real world.

Another way to put it is that you are adding apples to oranges. You then say the result is a dozen. I would much rather know how many apples and how many oranges there are. Adding them up doesn't add any insight to the matter. In fact information is lost in the process.

>> ROA as it’s commonly defined needs to go in the waste bin.

No.

IMO all the formulas for ROA produce a number that is significant.... from a different perspective!

If I were buying some bonds and wanted to know the ability of the company to service its debt, I would consider EBIT to be the more meaningful numerator.

As you rightly point out, ROA as typically defined is useful for calculating the productivity to the owner. Nothing wrong with that. The result is easily understood.

I would use them all when analysing a business just to get different perspectives. If you understand what it is a given formula spits out and what it is not, use it. If you don't, don't.

>> Useless Stock Metric #3: Enterprise Value to Free Cash Flow (EV/FCF)

Yes.

IMHO, EV means nothing. To make matters worse, Free Cash Flow can mean all sorts of things. So to me, #3 is a pretty useless metric. But if someone does understand what the formula produces, by all means, use it.

Some of those tools will get you in trouble if applied in the wrong context but that doesn't mean you need to replace the tool. Especially if the context that gets you in trouble is fictional (as with Montiers example).


Just some thoughts.

Please leave your comment:


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