4 Vanity Metrics that Feels like Investing but Means Nothing

Written by

Jae Jun

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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 2min 49s per visitor compared to 1min 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, go for a coffee break, or simply wait 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 Ratios

Previously I wrote about why you need to learn accounting.

To sum 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 its own

Some Examples of Vanity Investing Ratios

I do use the below ratios but I want to show you the proper way of using it.

  • EPS (Earnings Per Share)
  • PE (Price to Earnings)
  • PB (Price to Book)
  • ROE (Return on Equity)

Vanity Metric #1: Earnings Per Share

Earnings growth. Loved by Wall Street and most investors, but it really doesn’t tell you much.

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 $100k in earnings from $1m in revenue.

Now look at the two companies again.

  • Company ABC achieved revenues of $1m and net income is $100k.
  • Company XYZ’s revenue came in at $800k with other income of $200k making up a total of $1m revenue. Net income is also $100k.

With this extra information, you can see how different the two companies are. But most people simply look at the earnings line and judge the company based on a single number without taking the number in context.

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. Plus, 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 inclined to 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 is not as valuable as the company makes it out to be.

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 OK metric to a powerful one.

The best way is to use the DuPont analysis to break up ROE into 5 segments as shown below.

ROE dupont analysis

Via the five step model, the interest burden is increasing, but the main culprit is due to 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 Together

It is very important that you don’t just accept data at face value. Take things into 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 if important and really ask yourself whether it adds value to the overall investment.

If you saved a stock analysis and looked at it again 30 days later, are you confident that you will know why you saved it in the first place?

This is a problem I see with Wall Street analyst reports. I try to read it 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 or 19% year over year. Impressive but fluffy duffy stuff.

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    Another great article! I agree completely with not using EPS, it is a fake number. I more and more often look at cash flow first when earnings come out. Most of my best picks have been filtering the stocks that pass my screen for the ones with the lowest P/FCF.

    Most of wall street using EPS and P/E though. I do look at P/E vs. historical (how much is wall street willing to pay for company ABC?) & 1 year PEG (1-year EPS growth vs. 1-year forward looking P/E). My ideal stock is on that has EPS growth greater than historic P/E ratio and a 1-year forward P/E ratio less than historic (PEG < 1.0) and attractive FCF yield.

    For example, is company ABC usually trades 12-15x TTM EPS and next year has 15-18x EPS growth and currently trades at 10-12x NFY EPS, it makes it to the top of the list.

  • Ankit Gupta

    Great article, and I argue that we need more people to focus on concepts like this – a low P/E or even a high P/E can both be equally deceiving. Unusually low one-time earnings will result in an astronomical P/E ratio while unusually high one-time earnings will result in the opposite.

    I wanted to chime in on the P/B ratio, and my application of it.

    To the extent that there are no barriers to entry in an industry, I believe a 1x P/B ratio is often the justified one. Let’s think about insurance. For some insurers, 1x P/B (specifically, tangible book) is what they’re worth. If the industry’s cost of capital is, say, 8%, and companies are earning 10%, then competition is invited. Let’s say that the author, Jae, goes to start an insurer. With some data from Verisk, capital to please the regulators, and some employees, he can start an insurer. He can sell his products via independent agents who operate on commission. He has to simply offer a little more than competitors and/or offer pricing that makes their job easier. While launching any business is tough, it’s easier to launch something like this than to build a railroad – you need much more than $10-$30M for a railroad.

    Because building a business that produces insurance products is doable, and getting sales via agents isn’t impossible, we find that insurers of this variety (standard products with ISO pricing via Verisk, independent agent distribution, etc.) really do trade around that 1x P/B multiple. It can vary by time, so you might see a 1.2x average, but then we get into many nuances, like whether we agree with reserving practices at a specific insurer or not.

    I believe that while P/B ratios are not useful on their own, they can become useful with an understanding of many other aspects, especially the competitive environment, barriers to entry, etc.

    All that said… some firms do deserve greater multiples on the order of 2-3x book value. Barriers to entry and moats can, and do exist even in a field as commoditized as insurance.

    Hope you’re doing well Jae – sorry about spamming the comments :)

  • Viktor P

    Great article, I agree. We need to see what’s behind the numbers.
    I have a question, as someone who still needs to learn a lot.
    Are inventories and receivables supposed to be in line with EPS trend or go in the reverse direction? What’s the logic behind the reasoning? Thank you

  • http://www.oldschoolvalue.com/ Old School Value

    Inventories and receivables should be in line with revenue growth, not the EPS.
    Check out this article I wrote previously.

  • Viktor P

    Thank you. Sorry I am posting this so randomly, I am still getting used to navigating the website. Is there by any chance an article on manipulating the financial statements? (for example, revenue recognition practices, the right way to treat expenses, how to treat purchased in-process R&D etc.) Or do you have a good book that you could recommend? I am looking for a good book or article which would explain in a comprehensible way how the financial statements should be properly treated, what practices followed and what to be aware of (warning signs) when going through financial statements as a value investor? I have a 2 books so for (The Financial Numbers Game Detecting Creative Accounting Practices by Mulford and Comiskey; and Financial Statement Analysis by Fridson and Alvarez H) but I find them a bit confusing. I don’t know if all the practiced are accurate.

    Thank you.

  • http://www.oldschoolvalue.com/ Old School Value

    Yup I’ve already written a lot about financial statement analysis.

    Check out this link.

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  • switesh

    Putting the numbers in context – that’s the key phrase for me.
    Thanks for sharing this article Jae!

  • http://www.oldschoolvalue.com/ Old School Value

    Sure thing. Numbers are constantly thrown around out of context which is misleading and incorrect.

    That’s why ratios are always better than single line items because it combines two metrics to give you a proper message.