Around here, we try to look at things a little differently than the masses. It’s not that the masses are stupid, or necessarily wrong, it’s just that they’re a little lazy. Especially when it comes to investing.
So instead of people knowing the companies in their portfolio inside and out, we have a world where people will invest in a company based on a Twitter conversation or a Reddit post. I don’t think those people have any business investing in individual stocks, but hey. I’ll be a little patient with them. We all had to start somewhere.
So this post is for you, newbie investors. Here are five metrics that you’re using that you probably shouldn’t.
1. Price-to-earnings ratio
For certain companies, the P/E ratio is a pretty accurate representation of what they earn. Financial companies are a pretty good example of this.
But for many other industries, they’re a terrible tool. Why? Because of two simple little words — depreciation and amortization. Basically, D&A are the gradual writing off of an asset that deteriorates over time. Anything from real estate to office furniture is subject to depreciation and amortization.
What this does is decreases earnings in companies that are writing off large amounts of assets. Take Corus Entertainment as an example, I company that I own. Since it acquires a lot content pretty much continually, it’s constantly writing off huge chunks of depreciation. This affects earnings, but doesn’t affect its ability to generate cash. Corus might generate $200 million in cash flow, but only $50 million in earnings because of such high depreciation costs.
2. Payout ratios
Oh, if I had a nickel for every time I heard something like this:
“That company only earned $0.50 last year but paid out $1.00 in dividends. That’s a terrible payout ratio. STAY AWAY. DEATH TO ALL.”
You can’t figure out a payout ratio based on net earnings for many companies. Instead, you have to use free cash flow, which is cash from operations minus capital expenditures. From there, you see how much of the free cash flow gets used to pay the dividend.
Let’s use Corus as an example. According to Google Finance, it trades at a negative P/E, thanks to a $0.51 loss over the last twelve months. Most everyone looking at Corus would think its 6.5% dividend is completely unsustainable based on that.
But free cash flow tells a whole different story. Over the last twelve months it generated $154 million in cash from operations, invested $15 million in capital expenditures, and paid investors $75 million in dividends. Thus, the real payout ratio is about 55%, which is plenty good.
3. Return on equity
Here’s the deal with return on equity. If a company boasts really high ROE numbers, it’s usually a pretty good indication of profitability. But it could also show that the company is using a lot of debt.
Think about this simple example. A company generates $5 worth of earnings on $50 worth of equity. It then finances $500 worth of assets, using $500 worth of debt, which generates an additional $5 in earnings. Equity stays the same, but the return on equity increases to 20%.
Return on equity there looks great, but if you look at return on assets, suddenly the terrible investment becomes a reality.
4. Book value
As a value investor, my day is spent trying to find mispriced assets. This means looking at book value a lot.
It’s a fine metric, but you constantly need to make adjustments. Firstly, goodwill and intangible assets should be viewed with a very skeptical mind. 90% of the time I write them off completely and use tangible book value as my preferred metric. Typically goodwill is on the brink of being written off by the time I discover a company anyway.
Inventory is another tough one, especially with beaten-up retailers. Some value investors will assume a 50% discount, but I don’t go that far.
5. Quick ratio
The quick ratio is simply current assets (excluding inventory) minus current liabilities. I’ve used it before, but usually don’t even bother with it. Just about every company has the ability to borrow money in the short-term. If they’re temporarily a little short, it’s not a big deal.
Instead, I look at the trend. It’s obvious if a company is burning cash, since book value will persistently keep going down. Sometimes, a company will leave itself a little short. Usually it’s not a big deal.