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Metrics system - Valuation metrics can be great - if you use the right one for the right reason

04/09/2013

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

No two companies are exactly the same and so, over the years, various measures and parameters have evolved to facilitate comparisons between different businesses. Some of these so-called ‘metrics’ are relatively straightforward while others can be pretty complex but the key point for investors to keep in mind is any metric they do use should be economically or financially meaningful.

Some metrics really have stood the test of time, such as the perennially popular price/earnings or ‘PE’ ratio or – one of The Value Perspective’s particular favourites – the Graham & Dodd P/E.  since it uses the previous 10 years’ earnings of a business to gain a more normalised figure, you can always know the Graham & Dodd P/E with 100% certainty. there is no guessing or interpretation – it is all fact.

To our eyes at least, other metrics can appear a good deal less satisfactory – in Five signs, for example, we highlighted how a company can move away from using traditional metrics and come up with its own to make the business seem better value. ‘Adjusted earnings’ is a classic example while earnings before assorted other considerations should be seen as something of a generic red flag.

Sometimes investors will go wrong relying on metrics they should not – a textbook example being ‘clicks per eyeball’, which gained some popularity at the height of the tech boom. Other times they may use a perfectly good metric in the wrong scenario – as some equity investors currently appear to be doing with one known as ‘EV/EBITDA’.

Let’s leave the finer points of when and when not to use this idea of ‘enterprise value to earnings before interest, tax, debt and amortisation’ for another article and focus instead on the question of why significant numbers of investors can suddenly start using good metrics in a bad way or can latch onto plain bad metrics. to what degree does psychology play a part?

As the famous ‘conformity’ experiment conducted by psychologist Solomon Asch in the 1950s showed, for example, the desire to fit in with those around us can be a powerful motivator. In it, participants often changed their answer to a simple question so that they matched the responses of the majority who, unknown to them, had been primed to give the wrong answer.

Conjuring up a more arresting mental image is the experiment where five monkeys are put in a room with a ladder at the top of which is a banana. When one monkey tries to run up the ladder to grab the banana, it is drenched with a burst of icy water from a hose – as are the other four. All the monkeys soon learn not to approach the ladder.

One of the wet monkeys is then replaced with a dry one and, when it immediately tries to run up the ladder, it is set upon by the rest. When another dry monkey is introduced instead of a remaining wet one and tries to grab the banana, it is again attacked by the three remaining wet monkeys – and also by the first dry one.

Even when all five original monkeys have been replaced by new ones, any monkey that approaches the bottom of the ladder is immediately attacked by the rest – notwithstanding the fact none of them has ever seen the hose, let alone been drenched by it. None of them knows why they do so – in those dispiriting words of the Corporate Jobsworth, “That’s just the way it’s always been done around here”.

Unfortunately for science – if not for the monkeys involved – it appears this elaborate experiment may never have actually taken place in this form and the idea is more of an allegory for entrenched business thinking. even so, the moral holds true – think about what you are doing and why you are doing it or you risk being made a monkey of.

Author

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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