A great deal has been said about Michael Lewis' Moneyball at the Fool, and with good reason. Moneyball is one of those rare books that is able to take a specific subject, in this case baseball, and make the topic appealing to readers outside of its core audience. With so much great content available on the book already (check out the list of links at the bottom of this article, especially Tom Gardner's excellent interview with Michael Lewis), I will narrow my scope here to the one concept that immediately stuck in my head the first time I read the book: on base percentage.
The on base percentage revolution
On base percentage, and its lack of respect, is the theme that intrigued me more than any other because of how clearly it applies to investing. For years, baseball general managers have measured a player's offensive contributions using statistics such as batting average, home runs (power), and stolen bases (speed). None of these metrics are bad per se, but much like a low P/E, they don't paint the whole picture.
In Moneyball, what the Oakland A's have found is that while power is still important, the most important measure of a hitter is how often he doesn't make an out. The best way to measure this is by on base percentage, which includes not only hits, but also how often a player draws a walk or is hit by a pitch -- essentially any action that does not make an out, but gets the player on base. This intuitively makes sense, but for years big, slow guys who regularly get on base but don't have high batting averages have been labeled as non-performers.
To take it a step further, the A's and a few other teams have begun to blend together on base percentage and slugging percentage -- a measure of a hitter's power that offers more depth than home runs, because it includes all hits. With this blended ratio of on base percentage and slugging percentage, teams are able to more accurately assess the value of a player's offense and then pair that measurement with an assessment of a player's defensive abilities and personality.
It's a slow process, but as more and more teams begin evaluating players in ways that were once considered unconventional, the market for offensive value is being priced more efficiently.
Back in the investing world...
Talk to any value investor and you'll hear a similar argument: the key to success isn't so much the home runs you hit, it's avoiding outs. The P/E ratio -- what I consider the equivalent of batting average -- doesn't convey enough information to determine whether a company's shares are cheap or not and will keep you from making an out.
The investor's equivalent of on base percentage is enterprise value-to- free cash flow (EV/FCF). Much like batting average doesn't take into account walks, the P/E doesn't take into account the cash earnings of a company, and ignores the debt and cash a company carries on its balance sheet. Using EV/FCF will allow you to see a reasonable price for the shares of Boston Beer Co.
Still, a low enterprise value-to-free cash flow ratio used in isolation is dangerous in much the same way that a player with a high on base percentage can be a bad investment if that information is gathered over a short period of time or considered without other data points. A player with a history of injuries or in the twilight of his career is simply worth less than a player in his prime, whether you're referring to a player on the diamond or a company.
This is where value investors, such as Inside Value lead analyst Philip Durell, turn to discounted cash flow analysis. By making conservative estimates of a company's future earnings and discounting them back to the present value, investors are able to determine if a company like Mattel
What's it worth today?
If you turn your gaze to the market returns from this year, you'll see some rather disappointing numbers with the Nasdaq down approximately 14% and the S&P down a more modest 5% for the year. In certain circles, it has been a bit worse. Perennial all-star Starbucks
That may sound pretty bleak, but in truth, things aren't as bad as they seem. Despite all the talk about the economy slowing down and companies missing earnings by a few cents, there is always value in the market somewhere. And lately I've seen a little more value lying around in the market than I did just a few short months ago.
Get more for your Moneyball:
- Tom Gardner Talks to Moneyball Author Michael Lewis: Parts 1, 2, 3, 4, 5
- The Lessons of Moneyball
- Investing From the Ball Field
Interested in learning about more value in the market? Each month, Motley Fool Inside Value analyst Philip Durell highlights two promising bargains. Want to see what he has on deck? Click here for a risk-free 30-day trial to Inside Value. Or, for a limited time, take advantage of a 25% discount off our regular price.