5 financial metrics you should ignore when investing
This is a guest post from Troy at Market History. After reading the post here, be sure to check out his site. He has some excellent insights and analysis.
Every stock has a ton of financial metrics to look at. Most investors focus on a few that are the most important and easily comparable between companies. However, some of these financial metrics are absolutely useless! They have no predictive power and do not tell you how well a company will perform in the future. In the long run, growth in the company’s stock price will match growth in the company’s revenues and earnings.
Ignore the profit margin
Investors and the media tend to give extra kudos to companies with high profit margins. Their thinking is as follows:
- High profit margins means the company has an unassailable advantage in its industry. It also means that the company uses capital effectively. For example, Facebook has a profit margin of 27%!
- With such an unassailable advantage, these high profit margin companies must be the best growth stocks. They can use those profits to rapidly expand market share and conquer new markets.
This way of thinking is wrong. A lot of low profit margin companies such as Amazon experience rapid growth too. Meanwhile, high profit margin companies like Apple or high end fashion brands may experience slow or stagnant growth. A company’s profit margin is purely determined by the industry that the company is in. There are solid growth stocks in every industry.
Ignore industry growth
We’re often told to invest in companies whose industries are growing rapidly. A rising tide lifts all boats.
This is good advice, but it should not be followed to the letter. There are good growth stocks even in industries that are experiencing long term headwinds. An example of this would be Southwest Airlines. There is always room for a company to improve and beat entrenched incumbents in every industry.
Ignore year-over-year earnings growth
Earnings reports focus heavily on year-over-year earnings growth. Eg “our earnings grew 20% year-over-year! We had a great year!”
YoY earnings growth can be terribly misleading. A company that’s climbing out of an abyss might experience great YoY earnings growth not because the company is in a sound financial position, but because the company was in a terrible financial position last year. YoY is a relative relationship. If last year was a great year for the company’s earnings, it might have trouble growing those earnings this year. This does not mean the company isn’t a good long term growth stock.
In addition, you need to be careful about companies that increase their earnings by the same or very similar amounts quarter after quarter, year after year. It is not possible for a company to experience such consistent growth! This is usually a sign of falsified accounting, which led to the downfall of like Enron, Worldcom, and Tyco in 2001-2002.
Ignore earnings-per-share growth
EPS growth can be artificially generated, which is why this financial metric isn’t very useful.
In fact, artificially generating EPS growth is one of the oldest tricks in the book for corporate executives. During the late 1960s, a lot of large conglomerates artificially generated EPS growth by buying companies via increased debt. They knew that investors primarily cared about EPS growth, so the executives played this game without regard to the dangers of heavy debt. EPS growth does not mean that the company is a good long term growth stock.
Ignore “beats/misses” in earnings reports
A lot of investors care about whether a company beats or misses its earnings expectations. This is a ridiculous game. The best “analysts” don’t analyze much of anything. Corporate insiders give the analysts “hints” as to what next quarter’s earnings are going to be like.
When the executives know that the company’s earnings are going to decline, they simply help analysts lower their “expectations” so that when the company releases its earnings report, the earnings handsomely “beat” expectations.
Successful growth companies focus more on long term growth instead of pleasing Wall Street every quarter.