Do numbers really matter? Yes, unequivocally. Gauging a firm's value without cracking open its books is virtually impossible. There is a distinct danger, though, of getting lost inside operating margins, debt-to-equity ratios, inventory turnover, and capital expenditures. A company, after all, is a dynamic, multifaceted entity, not just a database of raw statistics. Sometimes, the variables that have the greatest impact on a company are decidedly non-numerical. And sometimes, to uncover the intangible factors that separate good firms from great ones, the last place you need to look is a 10-K report or an income statement.
Baseball fans might understand this concept better than anyone else could. The business world can't compete with the reams of baseball statistics that exist, and I'm sure that someone, somewhere, has calculated Mark McGwire's on-base percentage against left-handed pitchers in night games played in American League parks under a full moon. Students of the game realize that the compilation of hits, runs, errors, and WHIP ratios (walks, hits, and innings pitched, for those not in the know) is an effective way to measure each player's strengths and weaknesses -- but it is not the only way.
What about the speedy outfielder who hustles to cut off a hit into the gap and fires it back accurately to the relay man to prevent a larcenous runner from taking an extra base? What about the hitter who selflessly slaps a ground ball to the right side of the infield to advance a runner to third base with fewer than two outs? What about the aggressive slide into second base that breaks up a potential double play? These plays consistently lead to wins, yet they don't get recorded anywhere in a score book.
If picking winners were strictly a straightforward exercise in identifying which team had superior statistics, many of us might have lucrative careers betting in Caesar's Entertainment's (NYSE:CZR) sports book. If the strongest team on paper always prevails, then maybe we should prematurely hand next year's World Series trophy to the Yankees. Fortunately, plenty of external factors are at play to keep things interesting. You can't directly measure those factors, but their influence is clearly undeniable.
Likewise, some of the factors that distinguish minor-league stocks from potential all-stars are qualitative, not quantitative, in nature. When picking your roster, don't overlook these attributes:
Management
Why can Time Warner's (NYSE:TWX) Atlanta Braves alter their lineup drastically from season to season, shuffle their pitching staff, and still win an unprecedented 13 consecutive division championships? What's the one common element that remains the same each year? The answer: Bobby Cox, manager of the team, along with his coaching staff.
Without naming names, let's just say that even some of the greatest companies can fall prey to poor management and questionable corporate governance. Even if sales and earnings are accelerating, retained profits -- as my Foolish colleague Bill Mann pointed out recently -- can quickly dry up when management makes senseless capital-allocation decisions. On the other hand, some of the weakest firms can become stronger under adroit leadership. There's a reason so many seasoned money managers insist on meeting with a company's key executives face-to-face. All the great credentials in the world are meaningless unless a company has capable and trustworthy management at the helm.
Business model/strategy
Who doesn't recall the stories of all those venture capitalists a few years ago who invested in (and I use the term loosely) and subsequently lost millions on companies with no discernible business model, other than a dot-com at the end of the name?
When considering an investment, ask yourself: Does this company have a clearly defined game plan to generate sales and earnings growth? Where, exactly, do its revenues come from? What is its target market? What are its expansion plans? What differentiates it from its peers? Does it have any competitive advantages? Are those advantages sustainable? Is the strategy adaptable to an ever-evolving business environment, or is it static, rigid, and susceptible to obsolescence?
Having a better understanding of a company's business structure will also allow for keener insight into which metrics are of little value, and which bear the most intense scrutiny. For example, the focus might be on revenues per available room (RevPAR) for a lodging company, or net yields for a cruise line, or same-store sales for a retailer. Bottom line: Before you even begin calculating price-to-sales ratios, learn where those sales come from. If you see nothing compelling about a company's business plan, look elsewhere.
Economic moat
This term, coined by Warren Buffett, refers to a company's level of safety from competitors. Companies with narrow moats often face competition from every conceivable angle, while those with wide moats typically have to contend with the encroachments of only a few rivals.
Two prime examples include Moody's (NYSE:MCO), whose would-be peers in the credit-rating business must first meet stringent entrance requirements from the Securities and Exchange Commission, and Waste Management (NYSE:WMI), the trash collector that controls 40% of the nation's disposal capacity and around 300 landfills. Remember, an innovative new business model will attract not only customers, but also competitors. If only a shallow moat stands before newcomers wanting to jumping across, the likelihood of future price wars and/or leaking market share increases greatly -- just ask Netflix (NASDAQ:NFLX) shareholders.
Brand/reputation
When I asked my wife to name one stock she would buy without any numerical consideration, she answered Disney (NYSE:DIS) -- on the name alone. Of course, she also picks her horses at the racetrack strictly by their names. But still, to nearly every consumer, brand matters.
Assigning a monetary value to brand equity is tough, although it has been done -- with an approximate value of $68 billion, Coca-Cola (NYSE:KO) remains entrenched in the No. 1 spot on Business Week's "Global Brand Scoreboard." Cultivating strong brand-name recognition takes time, but well-managed brands almost always evoke a perception of quality that engenders loyalty and commands a premium price in the market. All things being equal, the scales should be tipped in favor of companies with popular brands and a positive corporate image, while companies with a tarnished reputation should be approached cautiously.
Industry: the bigger picture
The four factors above are all company-specific, but the industry in which a firm competes should also be an important consideration. Again, investors have another round of questions to ask. Is the industry emerging or mature? Is it ripe for consolidation? Is it prone to having its prospects altered? (Think of the curveball that the Food and Drug Administration just threw at the pharmaceutical industry, or the ongoing litigation that tobacco manufacturers face.)
From a macroeconomic standpoint, are there any catalysts that could cause the sector to quickly fall into or out of favor? Four years ago, not much in the numbers would have compelled investors to give Steel Dynamics (NASDAQ:STLD) a second glance; revenues were trending lower, and net income had just plummeted from $54 million to $3 million. Soon after, though, the imposition of import tariffs proved to be a boon to steel producers, and the company's earnings began to take off. Industry-wide, a $1.6 billion loss in 2001 swung to a $1.2 billion gain the following year. Of course, the growth of steel producers came at the expense of steel users: The auto industry posted a massive $7.6 billion loss.
You should also be aware that a stock can be judged harshly, or favorably, based solely on the company it keeps. Most real estate professionals will tell you to avoid the right property if it languishes in the wrong neighborhood.
Putting the pieces together
Attempting to analyze a company without weighing the factors above is no different from assembling a jigsaw puzzle with half of the pieces missing -- the picture may start to take shape, but it will be far from complete. Knowing that a firm has enjoyed steady earnings growth is not enough; Foolish investors should always look beneath the hood to determine what is driving that growth. Ultimately, the current reading on the speedometer will mean little if the engine begins to sputter.
A player who steals 50 bases per season can be a valuable addition to a baseball lineup, but the figure itself is largely just a function of an underlying factor -- speed. Throw a hamstring injury into the mix, and the once-valuable trait is suddenly lost. Similarly, financial measures are just a function of something bigger. A corporate "hamstring injury" can slow down even the most fleet-footed firm. Without a solid foundation in place, everything else can come crumbling down with the least financial tremor. After all, great numbers are not a cause, but an effect. Isolate what's behind those numbers, and then you can behold the complete picture of a stock's puzzle.
Time Warner, Moody's, and Netflix are all Motley Fool Stock Advisor recommendations. You can subscribe today with a six-month money-back guarantee.
Coca-Cola is a Motley Fool Inside Value recommendation, so if value investing is your thing, take a free trial today.
Fool contributor Nathan Slaughter owns none of the companies mentioned. The Fool has a disclosure policy.
