Sunday, June 25, 2017

Stock Metrics

How do you measure the worth of a company?

A reader writes, what metrics should we use to evaluate a stock or other investment?   Many other sites list what they consider to be the most important metrics.   And there are many.  What most financial channels concentrate on are often the most superficial metrics, while ignoring the most important ones.   The reality is, of course, that no one metric or group of metrics can guarantee whether an investment will succeed or fail.   That depends on a whole host of other factors, many of which can't be measured, can't be discerned, and are not available to you.   But of the major metrics, these are the ones readily available to you online.

This is by no means an exhaustive list!   Just the most obvious ones you see all the time.

Share price is the most obvious metric and one that the financial press harps on.  If you google a company name, you will be treated to its current share price and maybe a little graph showing the pricing trend today, as if you could glean something from this.  Does share price mean anything?   Not by itself, no.   Some folks argue that the efficient market hypothesis would indicate that share price is the communal assessment of the value of the company.  The "hive mind" has come to this price based on logic and value assessment.  However, as I have noted before, the hive mind can be lead astray - off a cliff, even.   So share price really is probably the worst indicia of the value of a company.   And it is the "metric" most touted by the media.

Share price over time (the first derivative of share price) is this little graph that pops up when you google the company name.   And you'd be surprised how many people follow share price from day to day, hour to hour.  A lot of middle-class and lower-middle-class people got sucked into "day trading" stocks, buying into some "system" sold on the Internet or on TV.  Some friends of mine here on the island got into it - telling me what a great deal it was and how I was a chump for not taking part in it.  After a few months, I asked them how it was going and they quickly changed the subject.   Gamblers remember their winnings, no matter how fleeting, but forget their losses.

I find these little charts to be of very little additional use than share price alone.   At the very least, expand the chart to five or ten years or "max" and see where the company has been.   Is the share price volatile?  If so, that is never a good sign.   Whether the share price is trending up or down, however, is of little import.   Many people try to read something into these charts.   Half look at a share price going up and say, "It's going up!  It will continue to go up!  I'm buying!"   The other half look at a share price going down and say, "It's going down!  It will surely rebound!  I'm buying!"  And since both parties are right half the time, they think they are winning at the game and prognosticating with accuracy.  However, without a time machine you really can't predict the future price of a share based on its past performance.

Market Cap is another largely useless metric that the financial press also touts.   It is basically arrived at by multiplying the share price by the number of outstanding shares and coming up with a number that means nothing.   It doesn't represent the "value" of the company or its power in the marketplace.   It is just a number, often arrived at because the plebes bid up share prices to the moon, not realizing that just because a company gets a lot of press doesn't mean it is profitable.   See Share Price and Share Price Over Time above.   The market is not rational and thus Market Cap is irrational.   I would just ignore market cap as a meaningless number that the press likes to throw around as it generates headlines.

Revenue is just the gross income of the company - what it gets for selling all its services or products for a year.  Revenue is another term the financial press loves to tout - and conflate with profits - particularly when they are hyping a money-losing company or a company that is making very small profits.   "Ajax company saw a 50% increase in revenues!" they simper in their headlines - not bothering to mention that Ajax saw a 50% decrease in profits at the same time.   Yes, you can increase overall revenue by slashing your profit margins and undercutting your competition.   It may not, however, be a sustainable model.  The financial press is fast and loose with these terms, often implying that revenue is profit or conflating the terms in financial articles.   I have met more than one person who has told me with a straight face that revenues and profits are the same thing.

EBITDA is a tough one to parse.   It is defined as a company's earnings before interest, taxes, depreciation, and amortization (hence the acronym).  It is an accounting measure calculated using a company's net earnings, before interest expenses, taxes, depreciation and amortization are subtracted, as a proxy for a company's current operating profitability (i.e., how much profit it makes with its present assets and its operations on the products it produces and sells, as well as providing a proxy for cash flow).   Quite frankly, I think this metric can be deceptive.   I am not sure why taxes are not just an expense, as is interest.   Why measuring a company's profitability while backing out these items is a better indicia of the overall worth or profitability of a company is a good question.

Some economists use this indicia to compare one company to another, in a hypothetical comparison where the two companies don't have any debt or pay any taxes.   Thus if Company A has a higher EBITDA than Company B, maybe Company A is intrinsically more profitable.   However, Company A has saddled itself with a lot of junk-bond debt and is based in a high-tax jurisdiction, which means it earns less real profit for shareholders, which is what really matters to you and me.

I think a lot of these day traders and other stock-schemers like to use EBITDA as it sounds really cool to say it, but at the same time, they really don't know what it means.   To me, net profits are what counts.  The fact that "but for" billions in junk-bond debt a company could be profitable really makes no sense to me.   After all, we can't wave our magic EBITDA wand and make those interest payments and taxes go away, can we?  So I am going to chalk this one up to another bullshit metric, particularly since I see it highlighted on day-trader sites.

Oh, and if you try to convince me that I am just too dumb to understand it, I will take that as a sign that yes indeed, it is utter bullshit when applied to ordinary investing.

EPS - or Earnings Per Share at least gives you some idea of whether the company is making money or not.  If this number is negative, well, the company is hemorrhaging cash and will have to either issue more stock, borrow more money, or find a way to make a profit, before long, before it goes bankrupt.   Many companies have negative EPS as they try to develop market share and new products.   So long as they have Billions in capital to burn through, maybe they can stay in business.  But eventually EPS has to go positive for any company - no matter what some wild-eyed "new paradigm" investor tells you.   Of course, you have to ask what exactly "Earnings" are, as some companies report earnings differently than others.  Traditionally this has meant profits, but others are using other indicia such as EBITDA (as noted above) so make sure when you are reading an indicia, it is the right indicia.  Other than being negative or positive, EPS by itself isn't a useful metric, unless you compare it to other metrics, such as share price...

P/E Ratio at least means something.   It is the ration of Price over Earnings.   So, for example, if your Acme company has a share price of $200 a share and earns $10 per share per year (EPS), its P/E ratio is 20, which is considered a pretty good ratio.   Flip the ratio over and you have an idea of that the company is earning per share, as a percentage.   In this case, about 5%, which is not a bad return on investment these days.

A lot of other people like to think of P/E ratio in terms of how many years you'd have to hold a stock to earn your money back.  So for example, our Acme company will earn back your investment in 20 years, which isn't too bad.   Some stock with a P/E ratio of 150 or more won't earn back your money until well into the next Century, by which time the company likely won't exist.   And that is something to bear in mind - companies are not forever, so don't think that investing for the "long haul" (50 years or more) in the same company is such a swell idea, if it ain't making money.

Dividends are very important in my book.   The represent a real cash payment into your bank account, not some theoretical "paper gains" as a stock price rises or "retained earnings" in the company.   Dividends are also a dirty word on the stock and financial channels and websites.   Stock price and capital gains are all that matters!   That's what they want you to believe, anyway.   But as I noted before - and as many other people have noted - dividend stocks tend to outperform speculative stocks (where you are gambling on the stock price alone).   And when you combine the gains in stock price of a dividend stock along with the dividends, the overall yield is far greater, on average, than most non-dividend stocks.

This is not to say dividend stocks are not without their problems - as I noted before.   You can't take one metric alone as an indicia of the health or prosperity of a company and where it is headed.   You have to look at the whole picture.

Dividend History is like share price history - it tells you about the past, but cannot predict the future.  For example, I invested in a trust of natural gas leases in Louisiana that seemed like a sure deal based on its dividend history.  Hey, everyone needs natural gas, right?   Well, then the gas glut came, and the company pumping the gas went bankrupt, and as leaseholders, our interest was basically wiped out in bankruptcy court.   Conditions changed, and past performance is no guarantee of future returns, as they say.

Similarly, I invested in some tanker stocks.  One did OK, the other not so well.   A recession in the shipping market meant that spot leases for tankers started to dry up and the ships sat empty not earning any revenue.   Also, the nature of these companies is that they pay out all their profits in dividends.  You are basically buying a piece of the tanker, and they pay dividends based on how much money the tanker makes, until the day they cut it up for scrap and you get a small piece of that as well and have a nice day.   High dividend yields sound great, but they don't go on forever, and again, conditions can change in any industry, and you have no way of predicting this without a time machine.  In fact, future business conditions are one "metric" that you can't measure with any accuracy, unless you could travel in time.

That being said, an old-line company that looks to have a steady future with a steady history of dividend payments is a reassuring thing.   Until that company goes belly-up when the market changes, or the CEO runs off with all the money.   Dividend history is helpful, it is not determinative.

Price to Book Ratio is touted by some at useful metric, but I am not so sure.  The price-to-book ratio (or P/B ratio) is an indication of what investors are willing to shell out for each dollar of a company's assets. The P/B ratio divides a stock's share price by its net assets, less any intangibles such as goodwill.  I find this a less useful metric, myself.  A company's "assets" are usually worth very little.   Even an old-line factory with lots of real estate and machine tools is worth very little in liquidation - as I have seen firsthand.

Go to any rustbelt City in the North and see all the abandoned factories that no one wants to buy.  Many are hazmat sites with PCB problems and actually have a negative value to a potential buyer.   Cities and States have to pay people to take these off their hands.   How do you think Elio ended up with the old Hummer factory?  No one else wanted it.   White elephant!

Machinery and other assets are similarly overvalued.   Old computers and office desks are worth nothing.   Machine tools and assembly line equipment, particularly specialized equipment, sells for pennies on the dollar.

More modern companies have little in the way of assets other than office leases, some servers, and maybe a computer or two.   The value in a company is literally in the people they hire, and in liquidation, you lose those people.

The real value of any enterprise is in the enterprise itself, not its liquidation value.   The ability of the enterprise to crank out profits and dividends is what really matters, not how much they paid for a robotic welding machine.

But there are uses for this metric as well.  If a company is trading below its book value, it may be very undervalued - or about to go bankrupt.   Take your pick - you'll need to look at other indicia to figure out which.

Debt-to-Equity Ratio is another metric which illustrates why "Market Cap" is bullshit.  The D/E ratio indicates what proportion of financing a company has received from debt (like loans or bonds) and equity (like the issuance of shares of stock).   As I noted in my Tesla post, many companies are raising capital today with debt, not stock, so counting only the stock as the "value" of a company is misleading.

But too much debt can mean the company is drowning.   Again, why EBITDA means anything is beyond me.  When you have billions in debt and high interest payments, it makes a difference even if your EBITDA numbers look good.

* * *
These are just a few metrics.   There are many, many more, including free-cash flow and price/earnings to growth ratio.   There is also a relatively new metric known as "Enterprise value" which some are saying is a better measure of a company's worth than "Market Cap" which may be true as Market Cap, in my opinion is essentially meaningless.

As an investor, you are lucky today in that many of these metrics are only a Google search away.  It was not too long ago that if you wanted to obtain much of this data, you had to subscribe to a data service or slog through annual reports (in paper form, of course!).   It simply wasn't possible to investigate a company's finances or its metrics, but then again, few middle-class people invested in individual stocks back the old days.

But you can measure all these metrics, find a company that looks good "by the numbers" and still lose your shirt.   Why is this?   Well, there are intangible metrics that are much harder to measure and discern.  A company may be coming out with a new product - or a competitor might be.  If the product is successful, the company making it may go up in value (and pay higher dividends) and the competitor may drop in value.   Or maybe the product will bomb.  It will injure customers, face massive recalls, or just be unreliable or unpopular.   Again, without a time machine, hard to know which is going to be the case.

Then there is fraud.   You can have all these great metrics going for you, only to later find out management was lying to you.   And that is what happened with Enron, who not only reported false financial data, but bribed and browbeat their accounting firm to certify these false numbers.  Both companies are out of business today.  If you went by the numbers, you'd be broke, as Enron certainly looked good on paper at the time.

That's why, I think another good metric is your gut instinct and skepticism.   Basically, anything hyped to you online or in the press is probably a bad bet - only you and 300 million other people know about this "hot stock tip!"   Similarly, anyone trying to sell you a system, predicting the end of the world, or using astrology to pick stocks (no, really, they exist!) should not be trusted.   You have to look at things rationally and not emotionally.

And you have to be prepared to miss out on great opportunities in retrospect and not let that bother you.   And you will lose money too, and you can't let that bother you either.   Diversifying your portfolio among a large number of things is really all you can do.   Trying to "win big" in every thing only insures you will lose big, all the time.

Because when you come down to it, you don't have the time and energy to research all of these metrics (and the many, many more), read all the news articles about a stock, examine the company's products, take a factory tour, listen on an investor conference call, interview the CEO, and consult with a panel of experts.   The people you are playing against in the marketplace can do all of these things.   Whatever you invest in, there is a guy on Wall Street who does nothing but think about that company or investment all day long.    Unless you are that guy, you will never reach that level of expertise.

For me, "gut instinct" means staying away from IPOs, dot-com stocks, and anything hyped by the shouting guy and the rest of the financial media.   If they tell me a stock has gone way up, then I know it is too late for me to jump in.   Does this mean I miss out on some things?  Sure.  But we all do.    I also made money on other things that other people missed out on.   Breaking free of the "I'll miss the boat!" mentality is, I think, key.   You are not entitled to, or should expect to, get in on the ground floor and make wild profits on all of your investments.  That just is not a realistic expectation in life.

My gut instinct also tells me that when something doesn't make any sense not to invest in it.  I'm not always right on this, but usually am right, which is better than usually wrong.

And all of this is why a lot of people put their money into mutual funds, index funds, and various other investments which require little or no thinking on their part.   Yes, even mutual funds have metrics, just like stocks and bonds and gold and anything else.   And they also have fees, which are a key metric of those investments.

After 30 years of this, I feel I am just beginning to get a glimmer of how much I really don't know about investing and how I am in a shark tank, when it comes to the market.   That only took 30 years, and at this point, the information doesn't do me much good, as I am riding the wave at this point.

The real key to investing isn't "beating the market" - which is nearly impossible for the small investor to do - but to save money and invest it.   Because at the end of the day, about half the money you have in your IRA or 401(k) will be the money you put there not the money you made from clever investing.

And if you don't put any money in there to begin with.... you will have no money at the other end, no matter how clever you are with stock picking and investing.   Metrics mean nothing, if you don't have money to invest in the first place.