Top 3 Useless Stock Metrics that Investors Use


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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 defunct 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
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

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

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

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

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

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) which doesn’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?

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15 responses to “Top 3 Useless Stock Metrics that Investors Use”

  1. Lenny Sims says:

    I think that you should do more research on these first. I will not say that I cannot agree with you, because when you take them narrowly you will draw your exact conclusions but when used with other measures you can see that they are quite effective.

    I cannot remember the book or author, but it might be shaunesey. I lent the book out, but he uses P/S with market leaders–the biggest baddest of an industry and PS works for and extra 1-2%.

    I do enjoy your articles though and appreciate all of your hard work.

    Thanks,
    lenny

  2. Collin says:

    I’m very confused.

    For P/S, even with leverage, why would you use $20/$12? Even with leverage, the price is still $100. Just because you bought a car with 80% debt doesn’t make the price of the car drop 80%.

    Could you please explain further?

  3. Collin Tan says:

    I agree with you. A single ratio by itself doesn’t do much. You have to use it in conjunction with other ratios.

    Every ratio has it advantages and limitations. I do not agree that the ratios mentioned in the article are useless. They have limitations, just like every other ratios.

  4. Collin Tan says:

    Brought up a good point on ROA calculation to include interest expenses. Some googling will show that some people has already include interest expenses to net income.

    Maybe it is time to update the OSV spreadsheet for the ROA calculation. Haha

  5. Steve says:

    In your price to asset case. Wouldn’t you use $6-$3.20/$20?. $20 is how much you have invested. As you make money your asset base increases. That is why real estate investors like the idea of leverage. Keep refinancing your rental property. Have as little invested in each property as you can. The other side of the story is the increase in risk.

  6. Steve says:

    As I lookup Return on Assets on investopedia I see that my comments is wrong. $100 is the correct number.

  7. Eric says:

    I work in Ag finance and we have always figured ROA with interest added into the numerator. I have always assumed that the ROA reported on NSN Money or Yahoo Finance was calculated the same way. Thanks for shedding light on this.

  8. Hi Lenny,

    Must give credit to the Finance Math blog. Ken Fisher is also a BIG proponent P/S but for the most part, I’ve found it largely ineffective. For a quant based strategy, it’s different because it probably includes debt based strategies together which is what you are saying. But even looking at leverage, it can provide misguided information.

  9. The $20 is the equity amount. If you do $100/$12, you really are only using equity. But if you also include $80/$20, you are mixing leverage with equity into the same equation which is incorrect.

  10. Samuel Goti says:

    I would be curious how EV/Sales would work instead.

    The problem is if you have two identical companies in every respect except one is financed only with equity and the other some mix of debt and equity, the levered firm will have a lower P/S than the unlevered firm. That makes it look “cheaper”, no?

    Basically if you sort on P/S, you’ll end up privileging high debt over low debt firms without any good reason. Some of that excess return will be due to the excess risk of the higher debt firms.

    But I do agree, it can work OK empirically (see the first figure in the Montier article I linked).

  11. Samuel Goti says:

    It shows up on other metrics too. In spite of the fact that internally Morningstar includes interest in ROIC, they exclude it in their ROIC metric on their site (see here for discussion).

  12. Accountant says:

    I don’t follow your discussion on point three. Cash flow from operations starts from Net Income, and so explicitly includes interest expense paid to bond holders. You have to subtract interest expense to calculate Net Income. I think it is then quite typical to subtract whatever your estimate is of ongoing capex to derive Free Cash Flow. The term can vary by analyst, so you need to understand how someone is defining it, but the treatment of interest shouldn’t be an issue.

  13. Mike says:

    What are your thoughts on cash adjusted P/FCF?

    For example: $1B Market cap, no debt and $500M in cash, with $100 FCF.

    Do you tend to view a company like this at 10x FCF or 5x FCF? Does the latter have merit to you?

  14. Received a comment on this. Reader is unable to post for some reason.
    ————————

    You’re just dead wrong on PSR. Cfr http://www.aaii.com/journal/article/what-works-key-new-findings-on-stock-selection?a=weekly10082013
    — if you’re not an AAII member sign up, it’s only $45/yr and worth a big
    multiple of that. In that article, James O’Shaughnessy (whom I sure
    hope you’re familiar with based on “What works on Wall Street” and
    other best-sellers) examines all metrics again for prediction power on how a
    stock price’s going to move, and concludes “the strongest individual
    factors come in and out of favor. The price-to-sales ratio and
    EBITDA-to-enterprise-value ratio vie for top billing, but it depends on the
    time period under review”.

    Dismissing either or both of the two most-predictive metrics
    as “useless” is, seriously!, hubristic to the point of stupid
    arrogance. Ken Fisher, the self-made billionaire, money manager,
    best-selling writer, and long-running Forbes columnist, who introduced PSR as
    THE metric to use 30+ years ago (in many columns, and in his best-selling book
    `superstocks`), has since pointed out PSR doesn’t often work any more because
    it’s too well known and widely used… but, there are specific situations where
    it still works just fine — and he hints at what they are in both of his latest
    best sellers (`the only three questions that still count` and `markets never
    forget, but people do`), as does O’Shaughnessy in the essay I’ve pointed you to
    (I don’t think there’s a new edition of `What works` coming any time soon,
    alas, but of course I’d snatch it hot off the presses if there were;-).

    Please DO research things in more depth before spouting off
    on them… WHY PSR sometimes (often, actually) works, may be murky; but that IT
    does (often, or at least sometimes) is just not debatable — it’s simple
    empirical data as carefully measured and highlighted by O’S. Calling
    reality `stupid` or `useless` doesn’t make it go away — it just makes you look
    like a bit of a jerk;-)…

  15. aleax says:

    Hi Jae and tx for posting my remarks on PSR before. Ken was essentially the one who introduced PSR as a key metric in his first (of many!) best-seller, `superstocks` — but in his recent books he’s pointed out that like any very popular metric it loses predictive power because the market prices based on it (and hints at where it still works — e.g, most foreign markets). O’Shaughnessy still sees it as one of the two best predictive metrics though (alternating with EV/EBITDA, essentially).

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