In my last post, I presented a series of questions that form the kernel of a qualitative checklist that I run on each stock to decide which of these may merit further investigations. The stocks that survive my qualitative checklist are then subjected to quantitative metrics checklist scrutiny, which will be the subject of today’s post.

The traditional method for stock screening begins with a list of quantitative metrics, used for stock screening. Depending on the type of investor or fund class, the stocks that satisfy certain criteria such as low- Price to Earnings ratio (a popular metric used to evaluate whether a business is a value or growth stock) are labeled as value stocks and others with high PE ratio are considered growth stocks. A basket approach to portfolio construction basically is designed around a collection of stocks that meet certain quantitative metrics criteria, resulting in products such as — value ETF, growth ETF, and mid-cap or large-cap ETF. A popular chart, the Style Map (shown to the right), is used to classify the investment style.

I am in the business of absolute returns and I have no desire to compare or evaluate my performance returns on relative basis, pegged to a given sector or style index fund. What that means for me is that my use of a quantitative checklist is primarily used to weed out stocks belonging to any sector, style, or size that I believe have a low future expected returns profile from the point of initiating a position in the stock.

The more I eliminate, the less work I have to do (laziness arbitrage at play here) and the less work I have to do, the more time I have to contemplate my actual investments and thereby have the courage to continue to hold those through periods of distress either micro or macro.

Now that I have explained the lens through which I want to view the utility of the quantitative metrics checklist, let us pour into the ones that I pay particular attention to. The list I present below is by no means exhaustive, but rather sufficiently diverse to allow me to form an opinion on whether I need to spend more time on the stock under consideration. Also note that to get a sense of how the business has performed over the years and where it stands today, I find it is useful to look at rolling-10-year averages for these metrics.

To the uninitiated, the financial jargon may sound somewhat un-wieldy. I may therefore try to use the analogy of owning/running a simple business such as a lemonade stand to explain the terms and their utility in evaluating businesses.

• Enterprise Value-to-Revenue (EVR) Ratio:

Enterprise value (EV) is simply the amount of dollars that needs to change hands for some one to buy out the business at any given point in time. In simple terms, one takes the market price of the business (no.of outstanding shares x price per share in the market), adds any outstanding debt that the business has adjusted for any cash/cash-equivalents in the business.

Revenue, is simply the sum total of money brought in by the business from business activities.

EVR provides a multiple on revenue that the business could trade hands at any given point in time.

To explain what EVR>10 means, here is a beautiful quote from the CEO of Sun Microsystems, Scott McNealy, ~circa 2002, when the markets were in the midst of internet-bubble valuations.

” At ten times revenues, to give you a ten-year payback, I have to pay you 100% of revenues for ten straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes that, with zero R&D for the next ten years, I can maintain the current revenue run rate [sic]. Now, having done that, would any of you like to buy my stock at U$64? Do you realize how ridiculous those basic assumptions are? You don’t need transparency. You don’t need footnotes. What were you thinking?”

Nothing can better describe the craziness of firms selling at >10 times revenue. Suffice it to say, they are easy to eliminate from any consideration for investing!

• Enterprise Value to EBIT Ratio (EV/EBIT):

EBIT stands for earnings before interest and taxes but after taking into account operating expenses and depreciation/amortization cost. There is a cost to running any business, from direct cost of manufacturing the goods being sold, to employee salaries and administrative costs to the cost of owning, maintaining physical locations to equipments etc. The funds from revenue remaining after taking into account these costs, is measured by EBIT.  Two additional expense line items are not taken into consideration with EBIT, which are interest on debt by the business and taxes on any net gains.

Interest on debt and taxes are a fixed cost for any business independent of business operations and hence to evaluate how any business is performing I like to look at EBIT.

One way to explain this criterion for me is to think in terms of yield on a bond. A stock with EV/EBIT>100 is a stock coupon yielding < 1 percent return per annum. Accepting ownership of such a poor-yielding high-risk asset must necessarily require some explanation, especially in todays environment of increasing interest rates, where one could get ~ 4 % annualized return on risk-free 2-year treasury bills.

• Return on Invested Capital (ROIC) compared to Weighted Average Cost of Capital (WACC):

ROIC and WACC, may need some explaining, which I do not think is warranted for this post. I will use lemonade stand business to explain in simple terms, what these terms are and how to interpret them. Invested capital in a business stems from two primary sources: share holder equity and debt financing. In the beginning, share-holder equity is basically the amount of capital invested into the business and debt is loans that the business may take to get up and running.

In the case of lemonade stand business, my son may decide to sell stake to investors (his friends in the neighborhood) to raise initial capital and borrow some fund from his parents. At the end of the year, my son tallies all the earnings from the business (after discounting for all the costs, which primarily are cost of lemons, sugar). He finds that his ROIC, earnings divided by the sum-total of capital put into the business, is 10 %. The question that he wants to ask, is it worth running the business for another year, especially considering the lost-opportunity cost of taking the same capital and debt and investing in “in-the-vogue” opportunities such as crypto.

Weighted averaged cost of capital (WACC) is basically a fancy way of measuring the opportunity-cost for continuing to run the business.

It should not take any fancy math to figure out that unless ROIC>WACC, ideally by a wide margin, it may not make sense to stay invested in the business.

• Return on Equity (ROE):

ROE is basically ROIC for firms that do not have any debt. Debt financing should only make sense if it can boost earnings. A simple way to check whether debt is beneficial or detrimental to firms operations is to see to make sure ROE > ROIC.

A quick look at these metrics, allows for evaluating the benefits of debt on the books on the firm.

• Retained Earnings:

I am in the business of trying to identify, buy and hold business with long-term secular growth. Retaining earnings basically refers to the amount of total assets from earning profits kept in the business.  It is an addition to the ongoing capital base of the business, which a shrewd capital allocator may find useful to further grow the business and thus put in motion the fly-wheel of sustained profitability and share-holder wealth creation.

There you have it, these are but a few key metrics that I want to look into before moving to the next step in investing process, which relates to answering the question: Should I buy now?

My next post will delve into my method for answering that question!