As a value investor, you have no doubt come across many of the key financial ratios, such as Price/Earnings Ratio or Price/Book Ratio. You may have also got used to evaluating businesses based on their operational metrics or profitability ratios. These are all very important, and as long as you review these regularly and understand what they mean, you will be able to find good stocks most of the time.
However, you have also realized that these ratios or metrics do not exist in vaccuum. They interact and influence each other in a number of ways, and often times it is not one metric that tells us what is happening in the business, but rather a combination of a few.
Today, we will list 6 of the most important financial metrics that you should consider before you make an investment in a stock.
Financial Metric 1: Piotroski F-Score
Piotroski F-Score is NOT a valuation metric. It is however a metric that tells you the strength and quality of a business’ operations and profits, and whether they are likely to continue.
I explain how to calculate the Piotroski F-Score in detail here.
Financial Metric 2: Altman Z-Score
Altman Z-Score is also NOT a valuation metric. It is however a metric that tells you the likelihood of a company going bankrupt in the next 2 years.
As a value investor, you are constantly looking for cheap stocks. Many times, cheap can be a minefield. Companies can be cheap for a reason, and while a distressed situation by itself should not be the reason to walk away, you need to know what you are going into so you can make appropriate adjustments to your valuations and expectations.
I explain how to calculate the Altman Z-Score in detail here.
Financial Metric 3: Net Current Asset Value
Net Current Asset Value has a storied past. Benjamin Graham was partial to the stocks trading at below their NCAV. This situation is arguably close to getting money for nothing, as an enterprising investor can engineer an orderly liquidation of the company in such a way that he can walk away with more than what he walked in with.
In short, the company is obviously undervalued, and if the reason is the management incompetence, a quick disposition of liquid assets can eliminate the management risk and return a profit to the investor.
Financial Metric 4: Margin of Safety
Margin of safety is an empirical estimate of the undervaluation of a stock. This is equal to the intrinsic value – the stock price. While the stock price is easy to find, estimating the intrinsic value of a company is an art that will differ from one value investor to another.
Many books provide methods that a value investor can use to estimate the intrinsic value. Discounted Cash Flow is one method, of which the Dividend Discount Model is a special case. You can also use the industry multiples of earnings or equity to estimate the intrinsic value. An experienced value investor has many tools in his arsenal that he can use to estimate the intrinsic value that he has honed over the years of experience in the market.
Financial Metric 5: The Graham Checklist
The Graham Checklist evaluates a stock on 10 different points. Each criteria that the stock passes awards it 1 point. All the points are added up with the result being a number between 0-10.
Stocks that score 9 and 10 are the best choices for value investors, regularly returning 50% or better returns annually. Unfortunately, these stocks are very rare. Stocks that score 7 or 8 can be great acquisitions and these are easier to find.
You can request a free copy of the Graham Checklist here.
Financial Metric 6: The Magic Formula
Popularized by Joel Greenblatt, the efficacy of the magic formula has declined over the years. This is easy to use and as a result is now widely used and therefore the stocks that meet the magic formula criteria get bought up quickly. The screen is still a worthwhile exercise as it can turn up some very nice undervalued and profitable stocks, so do not skimp on this.
You can read more about Magic Formula Investing here.
The Metrics 3-6 deal with undervaluation while the metrics 1 and 2 deal with the quality of the company operations and the quality of the financial management of the company (bankruptcy risk). To be a successful value investor, you need to pair up the underevaluation part with other qualitative factors so you can manage your risk and ensure that you are placing your bets of good jockeys (management).
Note: Most of these metrics require you to do calculations that can be a little more complex than a simple filter on P/E ratio. A good stock research tool is a must to have if you want to invest profitably. Without this, you will spend most of your time struggling with vast quantities of data.