All-Star Stocks: The Numbers

As my fellow Fools today provide an overview of their all-star investments, I thought it might be fitting to contrast some commonly used statistics in baseball and investing. In both pastimes, observers often rely on one or two standard metrics to make a decision, even though they can often be poor indicators of true performance. Whether you focus on financial analysis in investing or sabermetrics in baseball, the ability to evaluate a potential investment (whether it's a compelling biotech stock or a young, left-handed flamethrower) is critical. You've got to accurately interpret the available data to separate the pretenders from the true all-stars.

Batting average and P/E ratio
Mention how good a season David Ortiz is having for the Red Sox, and the first response will likely be, "What's he hitting?" Similarly, if you tell someone about a bargain company, they often respond, "What's the P/E?" If you answer .278 to the first question or 20 to the second, a seasoned analyst will likely assume that your knowledge of both hitting and valuation needs some refinement.

However, if you really wanted to assess David Ortiz's season at the plate compared to other players, you'd want to examine his on-base percentage (OBP), slugging percentage (SLG), runs created (RC), or, if you're really ambitious, equivalent average (EqA). The latter takes a great deal more effort to calculate, but it gives a player's total offensive value per out. These figures all show that Ortiz's .278 batting average is a misleading indicator of his overall performance this season.

The same principle is true in investing. If we use American Eagle Outfitters (NASDAQ:AEOS) and Abercrombie & Fitch (NYSE:ANF) as examples, we see some interesting differences that aren't readily apparent from the P/E ratio alone.

Based on free cash flow and owner earnings, American Eagle Outfitters actually looks cheaper than Abercrombie & Fitch, despite its greater P/E. American Eagle's free cash flow is twice Abercrombie's, and its owner earnings are considerably larger as well. The argument could be taken a step further by noting that Abercrombie is expanding three concepts, while American Eagle is only currently operating stores for one; that extra expansion is depressing Abercrombie's free cash flow. As you can see, it takes multiple data points to come up with an accurate assessment of any one company.

Heading for home
Baseball and investing fans alike hold many other imperfect statistics and metrics in high regard. Earnings per share and runs batted in are two great examples; they don't convey much useful information unless you take a number of other factors into account.

None of these metrics is bad or flawed. A low P/E ratio can indicate that a company is cheap, but it isn't a good way to measure a company's valuation. If you still have doubts, ask investors in cyclical companies such as Alcoa (NYSE:AA) or Electronic Arts (NASDAQ:ERTS) whether they consider the P/E ratio a good indicator of value. They'd probably tell you that you need to dig a little bit deeper, examine free cash flows, and then perhaps build out a discounted cash flow analysis. It's more work, but the effort is worth it when you're trying to build an all-star team with your own hard-earned money.

Take a swing at further Foolishness:

• All-Star Stocks: Swinging For Growth
• All-Star Stocks: Netflix Goes Yard
• All-Star Stocks: Grand Slam Biotechs

Electronic Arts is a Motley Fool Stock Advisor pick. Let Tom and David Gardner pitch you more of their favorite stock ideas with a free 30-day trial subscription.

At the time of publication, Nathan Parmelee had no financial interest in any of the companies mentioned.