Which Metrics Really Matter for Stocks

One of the most interesting and misunderstood subjects in the stock market is why stocks go up and down.

The academic view is that the value of the stock is the value of "discounted future cash flows" and represents the economic value of the underlying company.

Anyone who watched the "meme stock" action knows that certainly isn't true in the short term!

We have our views and often remind readers that "stocks are not companies."

Yes, there is an underlying relationship between the stock and the company. You technically own a piece of the enterprise and – in theory – a right to those cash flows.

However, the reality is that most investors will never see any of those cash flows.

We always use the example of Amazon.com, Inc. (NASDAQ: AMZN).

The company went public at a valuation of $300 million in 1997 and today has a market capitalization of almost two TRILLION dollars!

Do you know how much of the "cash flow" AMZN investors have seen in those 27 years?

Almost none of it!

The company has only recently started buying back stock and still doesn't pay dividends. This has not been the wrong move, as they have used that cash to re-invest in the business and create tremendous value.

The reality, though, is that public shareholders have seen none of this cash. The argument about the value of a stock being the sum of the discounted cash flows becomes difficult for me if investors never see the cash!

That being said, AMZN has created enormous economic value. As a public shareholder, you DO own a piece of that company and its economic value.

If they don’t return the cash, though, what is it that drives stock prices up?

Wall Street uses a term they call "metrics."

This stands for the different financial statistics that the company reports. Some are the biggest and most important, like sales, gross margins, operating profit, free cash flow, and net income.

Other "metrics" may include future billings, backlogs, deferred revenues, number of customers, etc.

Each industry has particular metrics, and Wall Street analysts look at hundreds (thousands) of them.

Which ones matter the most?

In the long-term, our view is that it is profitability.

Regardless of whether a company is returning the cash to the shareholders (in the form of buybacks or dividends), it is essentially a law of physics that if a company grows its "earnings" from "x" to 10 "x," the stock will go up.

The measure of earnings could be any number of metrics—operating cash flow, net income, EBITDA, EPS, free cash flow, etc.

We will emphasize that if a company grows its earnings metrics a lot, then the stock will go up a lot. The opposite is also true – a company that sees its earnings metrics go down a lot will almost always end up going down themselves.

This is the long-term rule, but what about the short-term?

Here is where it gets trickier, and there are a thousand different answers.

The honest answer is that whatever the analysts (brokerage analysts and owners of the stock) decide is the metric that counts!

For many early-stage companies, this might be customer count. For drug companies, it might be test results. For software and industrial companies, it might be their billings or backlogs.

We don't spend much time trying to justify why a particular "metric" is a focus of investors. However, we try to quickly identify which metric is the one on which they are most focused!

That is all that really matters. If a large group of analysts and shareholders deem that a particular metric is the one that counts, then you need to understand the metric.

Which metric can also change through time. Early in a company's life cycle, customer acquisition metrics might be used. Later on, it might be revenue per customer. Even later, it might be cash flow.

Don't worry so much about what the metric means for the company financially, but instead focus on knowing WHICH metric the buyers and sellers of the stock focus on.

In the long-term, the most important metrics for stock price performance are always the same – PROFIT! 

In the short term, let the market tell you which metric it cares about, and use that to guide your trading strategy.

The HX Research view on the importance of metrics goes against much of the conventional financial analysis consensus. Do you agree or disagree with our approach? Let us know in the comments section online or email us at [email protected].