Geoff Gannon June 29, 2010

What are the 4 Most Important Numbers to Know About a Stock?

A lot of investors think they have to be scientists. They have to be rational. They have to be objective. And they have to weigh all the facts equally.

Some of those are good ideas. Others aren’t. Yes – You need to be rational when judging a stock. But I’m not sure you need to be objective. Let’s talk a bit about that.

I’ve said before that if you want to become a better investor, you should think less about stocks and think more about thinking.

Thinking about how you think is not objective. But it is rational.

Being objective means focusing on the stock instead of the investor. Scientists write papers from an objective view. They describe their experiments in a way others can copy. They don’t make science personal.

So why should you make investing personal?

Because it’s safer that way.

There’s a great book called

The Checklist Manifesto: How to Get Things Rightir?t=gannononinves-20&l=as2&o=1&a=0805091742

. It talks about how checklists can be used to break complex tasks into simple steps that prevent mistakes. Not just for amateurs. But for professionals. For experts.

People like doctors, pilots, – and yes – even investors make fewer mistakes when they use checklists.

I’ve talked about checklists in the past. In “Investor Questions Podcast #11: Why Does Evergreen Energy’s Stock Always Go Down?”, I said you should focus on stocks with Z-Scores of 3 or more, F-Scores of 3 or more, and 10 straight years of positive free cash flow.

I still think that’s a good idea. Investors who stick to those rules will make fewer mistakes than investors who don’t.

But that checklist isn’t good enough. There are other mistakes you can make. The checklist I gave you in podcast #11 won’t protect you against all of them. The most important rule I left off was price. Investors who don’t add a price rule to their checklist can still lose a lot of money.

I’ll give you a fuller checklist later. For now let’s talk about why you need a checklist in the first place.

I want you to take off your lab coat and put on a fedora. Stop thinking of yourself as a scientist and start thinking of yourself as a detective.

You walk into a hotel room. There’s a dead man in a business suit lying face down on the carpet.

The hotel room is full of clues. Dozens of them. But how do you know what’s a clue? How do you make sense of the data?

There are two ways to tackle this problem. One way is to start in gatherer mode. You walk around the room looking at stuff, taking pictures, and writing things down.

The other way is to start in hunter mode. Instead of starting with the data you start with a theory. Or a question. Or a hunch. You follow that thread as far as it takes you.

Which way is best?

I don’t like either of them. The gatherer mode is hopeless. You could walk around the room and look at everything. But that won’t get you anywhere. You’ll end up with hundreds of pieces and no idea how the puzzle fits together.

Now that doesn’t mean taking an inventory of everything is wrong. I actually like that idea. But that’s not analysis. That’s something anyone can do. It’s important work. But it isn’t the analyst’s main job. It’s basically a reporter’s job. It’s just taking everything in the room and putting it into a standard form that will make sense a week or a month or a year from now when someone wants to look at all the evidence.

So I’m fine with the gatherer approach up to a point. Finding a stock’s price-to-earnings ratio and price-to-tangible-book ratio is fine. It may even be important. But it’s not analysis. And unless you have a theory to hang those numbers on – they won’t do you much good.

Let’s say you know a stock’s price-to-earnings ratio is 9. Fine. What does that tell you? It tells you the stock might be interesting. It might be cheap. But now you need to ask if those earnings come in the form of cash. Like I said in “Investor Questions Podcast #4: What is the Difference Between Earnings, Free Cash Flow, and EBITDA?” – a railroad with a price-to-earnings ratio of 9 is a lot more expensive than an advertising agency with a price-to-earnings ratio of 9 – because railroads need to plow most of their earnings back into the business. Advertising agencies don’t.

Where in the business cycle are we? Is this a bank or an insurance company you’re looking at? If it’s a bank, an insurance company, or a homebuilder – where we are in that industry’s cycle matters a lot. Banks can earn a lot of money right now because the Federal Reserve is pushing short-term interest rates down to zero. Will that be true in the future? No. Not forever.

The same thing is true when times are good in the insurance business. A low P/E ratio might not mean much in good years. It means a lot in bad years. You have to look at the long-term combined ratio for the insurance company you’re interested in and compare it to the long-term combined ratio for the industry. If they’re both lower this year than they have been in 5 or 6 years, that low P/E ratio isn’t as great as it sounds.

But you know all this. That’s why you asked the question. You said you’re confused. I don’t need to remind you how complicated things are.

And they are complicated. There are a lot of numbers to look at. But I hope you see how I’m looking at them. I’m starting with the number that catches my eye – like a low P/E ratio – and then I’m following that thread where it takes me. I’m asking follow up questions.

Whether you want to think of yourself as a reporter or a detective doesn’t matter. But you need to remember your job is to ask questions. Don’t just gather clues. Follow leads.

Now that I’ve told you to follow leads instead of gathering clues, I need to give you a warning.

I don’t want you to start by following leads right away. You’ll jump to conclusions if you do that. And you could make dumb mistakes that are hard to fix later.

So the first thing I want you to do when you walk into that hotel room is look at your checklist.

Think of yourself as that detective. What checklist should you use?

Once again, here’s the scene: you walk into a hotel room; a dead man in a business suit is lying face down on the carpet.

Before you start gathering clues and following leads, what simple steps do you need to take?

A good way to figure out which steps to put on the checklist is to start by thinking about the mistakes you can make. What can go wrong here? What can you do in the first few seconds to screw up your investigation for good?

Think of your unspoken assumptions. Now try to say them out loud.

I’ll list a few assumptions a lot of people make in this position. See if you made any of them.

Unspoken assumption #1: The man died violently.

Unspoken assumption #2: This is the dead man’s room.

Unspoken assumption #3: This is where the man died.

Unspoken assumption #4: These are the clothes the man died in.

The first assumption, that the man died violently, is the one you’re least likely to make because you’re focused on it. How the man died, whether it was murder, and who the killer was are the questions your mind automatically jumps to. So you probably didn’t make that assumption.

The other assumptions are more common. Assuming the dead man is the guy who rented the hotel room is an easy mistake. It’s also a big mistake. Making that assumption, and being wrong about it, can cause your investigation to fail in a way you can’t fix later. The man or woman who did rent the hotel room will be long gone if you don’t get this question right from the start.

The good thing about these mistakes is that they’re easy to avoid. As soon as you walk into the hotel room – you can look for signs of violence, check the body for identification, look for signs the body was moved, and check to see if the dead man’s clothes are on right. After you’ve checked those 4 things you can start gathering clues.

Jumping over those 4 steps would be bad. Especially if this isn’t the dead man’s hotel room. Making that mistake would cause you to misinterpret everything in the room. You’d head down the wrong path and none of your work would matter.

What does this have to do with investing?

I started by talking about a crime scene because I figured books and TV have taught you to think of crime scenes as mysteries instead of data dumps. Most people try to figure out a murder.

Not everybody knows they need to figure out a stock.

The question that matters in a murder is who the killer was. The question that matters in investing is whether or not you should buy the stock you’re looking at.

That’s it. All the work you do has to help you answer that question: should you buy the stock?

Now let’s talk about how I want you to start your search for an answer.

When you find a stock you’re interested in, start by thinking of yourself as a detective standing over that dead body. Start by thinking about the dumb things you could do right now to screw up your investigation forever.

Start by thinking about a checklist. The book I mentioned before, “

The Checklist Manifesto: How to Get Things Rightir?t=gannononinves-20&l=as2&o=1&a=0805091742

”, spends a lot of time talking about doctors and hospitals. That’s because the author is a surgeon. Regardless, medicine will work as a good metaphor here because we’ve all seen plenty of doctors in fact and fiction.

Hospitals take patients’ vital signs. A patient’s vital signs are: body temperature, heart rate, blood pressure, and breathing rate. All 4 signs are easy to take and can be put into numbers. There isn’t a lot of room for interpretation when measuring the 4 signs. What they say about the patient is open to interpretation. But the 4 numbers are easy to record and easy to read. They are put in numbers every doctor can understand.

Hospitals take vital signs to prevent a failure that can’t be fixed. The 4 numbers are warning signs that make sure doctors and nurses don’t ignore a problem that could kill a patient.

Investors should look at stocks the way hospitals look at patients. Start with the vital signs. You want numbers that aren’t open to interpretation. They need to work as warning signs. And a few numbers should tell you most of what you need to know.

I suggest using 4 vital signs: 1) Z-Score 2) F-Score 3)10-Year Free Cash Flow Margin coefficient of variation and 4)10-Year Real Free Cash Flow Yield.

Recording these 4 vital signs will keep you from making most mistakes. I know that’s hard to believe. But it’s true.

If you take the time to calculate these 4 vital signs before researching a stock any further you’ll keep yourself from making most mistakes.

I like to write the ticker symbol of the stock on the front of an index card and record the stock’s 4 vital signs on the back. That way whenever I think about the stock, I can see the 4 numbers right there in black and white.

It’s hard to lie to yourself about how safe a stock is when you see a Z-Score of 1.5 staring back at you. It’s hard to tell yourself a stock is cheap when you see a real free cash flow yield of 3% on that card.

I love this approach. It works for me. It’s made my investing much safer. Most of the mistakes I made in the past would have been avoided if I had been using this approach back then.

This method may not work as well for you. I think it will work. But it probably won’t work as well as it has for me. That’s because I designed this method based on my past mistakes. Not your past mistakes. Every investor is different. You make different mistakes than I do. So my method will miss some stuff you do wrong because it’s tailored to my weaknesses instead of yours.

I still think using these 4 numbers will cut your mistakes down.

But a lot of investors don’t like this idea. I can see why. It’s limiting. And it makes you feel like a baby. It’s as if I’m saying you can’t trust yourself to make investment decisions.

I’m not saying that. But I am saying we all make dumb mistakes. Even experts. And a few simple numbers can keep you from making most of those mistakes.

I talked about the Z-Score in “Investor Questions Podcast #13: How Do Find a Stock’s Z-Score?”. And I talked about the F-Score in “Investor Questions Podcast #12: How Do You Find a Stock’s F-Score?”.

I haven’t talked about real free cash flow yields. And I haven’t talked about coefficients of variation. Those terms sound scary. But they’re not. You can figure both out in seconds using Microsoft Excel.

I’ll show you how over the next two days. Episode #15 will be all about the 10-year free cash flow margin’s coefficient of variation. I know it sounds strange and boring and maybe even a little mathy, but it’s one of my all-time favorite numbers. Hopefully my enthusiasm will rub off. Then on Thursday, I’ll talk about real free cash flow yields. They’re even easier.