16 June 2007

Another Tweak to the Gauge Scoring

The interlude between first and second quarter earnings reports has afforded us an opportunity to try out some improvements to the financial gauges. First, we expanded the Cash Management Gauge to include three additional metrics. Then, we adjusted the weights assigned to each metric that is an input to one gauge or another.

Today, we're announcing that the PEG ratio contribution to the Value Gauge has been replaced with Enterprise Value (EV)/Cash Flow from Operations (CFO, or OCF).

The P/E to earnings Growth (PEG) can be a very important ratio. Many analysts will say that shares of a company are inexpensive when the P/E is less than the earnings growth rate in percent; i.e, when the PEG is less than 1.0. By this reckoning, a company growing its earnings at an annual rate of 20 percent would be a good value when the P/E is below 20. Conversely, shares are deemed wildly expensive when the PEG exceeds, say, 2.0.

The growth rate in the PEG should be the percent increase expected in next year's earnings relative to the current year. This is called forward earnings growth, in contrast with backward-looking trailings earnings growth. Alas, forward earnings growth predictions are very subjective. We sought to avoid this problem by using the trailing earnings growth to calculate PEG; however, this hasn't worked out very well. Too often, we've seen negative correlations between our PEG score and future stock price moves. So, we decided to nix the PEG for something else.


Despite its arcane name, Enterprise Value / CFO has similarities to the basic P/E ratio with which readers are well acquainted. The "P" in P/E represents the company's market value; i.e., what the price would be to buy every share outstanding. However, the real world is more complicated: the purchaser also has to deal with the company's debt. The EV better reflects the cost to the purchaser. It adds debt (long- and short-term) to the market value, but subtracts the company's cash and short-term investments (which could pay down the debt or offset the cost of the share purchase).

The "E" in P/E obviously represents earnings, and CFO is just another measure of how much money the company is bring in from its core business. Some say that CFO is harder to manipulate than income; we're not sure whether that is true, but cash does have the benefit of being a tangible asset. Our frequent readers know that we use the Accrual Ratio in the Profitability Gauge to distinguish earnings due to cash flow from earnings due to Balance Sheet changes.

For each 5 percent a company's EV/CFO is below its average over the previous four years, it will get one point in our scoring system, with a maximum of five points.

We'll see how well all these adjustments work out when we're analyzing the impending flood of second quarter reports. The beneficial changes will be retained, and the others will be modified discarded. We don't expect to ever stop searching for improvements. While the adjustments change scores that were published previously,we will always use a consistent basis when comparing new scores to old.

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