It's all too appealing to try to reduce investing to simple numbers. An undervalued ratio here, an above-average metric there, and you're good to go, right? Well, maybe not. Although numbers have their place, they must be kept in their place -- that is, as an aid to analysis and decision making, but not a driving factor. I believe that when investors look back on the history of successful companies and winning stock picks, they will see that true value is not just a sequence of numbers.
Numbers don't tell the whole truth
Many different dead people are reported to have originally uttered the line "lies, damn lies, and statistics." Whoever actually said it was on to something. Numbers may be a convenient measurement tool, but what happens when management decides to tinker a bit with them? How many people bought into the Enron or WorldCom stories because they were seduced by the numbers?
Apart from these two examples of outright fraud, there are numerous companies that actively attempt to manage their earnings. A change in inventory valuation here or a readjustment of depreciation schedules there and you can smooth over quarter-by-quarter or year-by-year comparisons. Maybe this isn't a blatantly "bad" thing -- after all, investors seem to like steady growth in earnings and stock prices -- but it does point to a reason as to why you might not want to place undue reliance on the numbers.
Let's also not forget that accounting isn't necessarily meant to be used in the way that many investors try to use it. Modern accounting principles are mostly built for the purpose of tracking the movement of cash into, around, and out of a business entity. As such, it has certain limitations.
For instance, accounting treats most research and development as an expense, yet clearly companies view R&D as at least partially an investment in future products and competitiveness. If R&D is simply an expense and not a cumulative asset, why then are biotech, med-tech, and some technology companies acquired when they have no earnings and no products yet on the market?
Likewise, why aren't capital expenditures treated as an expense? Sure, you can argue that depreciation is a proxy for the need to replenish the company's capital base, but there is no requirement for a company to distinguish between "maintenance" capital expenditures and growth capital expenditures. Likewise, assets are frequently depreciated irrespective of their actual current values -- meaning that some companies may hold property that is worth little on the balance sheet (because it has been depreciated), but worth quite a bit in real life.
Simply put, modern accounting is not concerned with what really matters in evaluating a successful business -- producing an economic return on capital that is in excess of the cost of that capital. Sure, you can (and have to) use accounting inputs like pre-tax profit in your calculations, but ultimately you need to leave accounting behind to establish reasonable estimates of discounted cash flow, economic value added, or many other methods of company valuation.
Management trumps numbers
It seems as though some people forget that numbers don't run businesses -- people do. And above-average people have proved time and time again that they are capable of doing far more than what mere numbers would suggest. In other words, good management trumps numbers.
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Simply put, you can't quantify the above-average opportunities that are created by talented and visionary managers. Unfortunately there is no price-to-creativity ratio, nor a way to measure return on management vision. Sustainable competitive advantages and economic moats are hard to quantify much beyond "I know 'em when I see 'em," and yet they are critical components to long-term stock market success.
In the absence of a Michael Dell ratio, remember that numbers are either reflective (looking back on reported results) or prospective (projecting future results), but they themselves don't produce anything. One person may build a model showing Overstock.com
Cheap can be cheap for a reason
Perhaps it's because I identify myself with the value crowd, but I happen to think that value investing is the most misunderstood investment philosophy. Look at a lot of popular investment books and you get the sense that value investing is all about numbers -- P/Es, price-to-book ratios, and so on. This not only gives short shrift to what real value investing is all about, but it can be dangerous for the novice or lazy investor.
Too often investors look only at a P/E ratio or maybe an enterprise value-to-free cash flow (EV/FCF) ratio and declare a company "cheap" or a "value stock." Unfortunately, these cheap numbers are easily misunderstood. Cheap is not cheap if the company is at a cyclical peak and earnings are about to go into decline. Cheap is not cheap if the company or industry are no longer competitive and are instead doomed to eventual decline (consider Berkshire Hathaway's namesake investment in the textile industry).
Likewise, a company about to begin a cyclical upswing will not look cheap. A company that has staunched the bleeding and begun a turnaround will not look cheap. A company with a proven competitive advantage and a solid growth outlook will not look cheap. And yet, all three of these archtypes can certainly be core value investment ideas.
What "real value" is
So if value isn't to be found hidden in a ratio or buried in a formula, where do you find it? Ideally, real value is a long-term competitive advantage purchased at a good price that includes a margin of error. I say "ideally" because cyclical companies and turnaround candidates can also be true value stocks if purchased correctly -- the long-term sustainable competitive advantage may be lacking, but a large enough discount to intrinsic value can make up the difference.
Identifying quality turnaround and cyclical opportunities is a subject for another day, so I'll instead focus on some thoughts about core value companies. These are companies with strong economic moats -- sustainable competitive advantages that help to insulate the company from competitors and allow for above-average earnings growth. These are also companies that produce real economic value -- meaning that they can take a pool of capital and reliably achieve financial returns well in excess of the cost of that capital. That might seem simple and obvious, but not many companies manage to do it for the long term.
Last, but not least, real value is a company that has a great management team with access to reasonably priced capital and free economic opportunities to expand. Don't overlook this latter point, as few companies can match Motley Fool Inside Value pick Coca-Cola
We look for real value
Don't worry -- you're not out on your own looking for true value opportunities. We have an entire team at The Motley Fool that does little else but look for high-quality companies trading at very attractive prices. This Inside Value team has already done quite well for its subscribers, and I believe that any investors who want to appreciate true value investing should at least take a 30-day trial subscription to the newsletter service.
Remember, value isn't a number. There is no ratio or combination of formulas that can reliably guide you to true value opportunities. Successful investing is not mechanical -- it's subjective and qualitative. Numbers are a crucial part of the process and can reveal important information, but they must be kept in context. Like light reflecting off a mirror, investors should remember that numbers can reflect the state of a company -- but they aren't themselves the company. By looking beyond the numbers and appreciating them in context, investors can unearth the true values in the stock market and beat the conventional averages.
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Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares). Amazon.com is a Motley Fool Stock Advisor recommendation. Overstock.com is a Motley Fool Rule Breakers recommendation. The Motley Fool has adisclosure policy.