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How to pick stocks with a difference

Regular Fool readers will hopefully be familiar with the basics of stock picking. Stocks might be picked because they are cheap (value investing), pay more dividends than average (income investing), or are expected to rise in price dramatically (growth investing). Identifying potentially outperforming stocks might involve looking at price-to-earnings ratios and estimates of revenue growth, and comparing dividend yields and profit margins.

But there are alternative ways to look at companies, outside the basic investment toolkit, that might yield additional insights. It is, however, important to point out that all metrics are almost useless in isolation. They are useful in judging performance over time or comparing similar companies. Entire industries can be compared with aggregate metrics. When picking stocks, an investor is looking for the best, and the best is only evident in comparison.

Drilling down on differences

Some novel metrics make sense for looking at any company in any industry. Looking at revenue per employee (RPE) can help measure how productive a company’s workers are. If a company spends millions installing new IT systems, looking at how RPE changes over time can help assess the effectiveness of the upgrade.

An investor might want to divide a company’s revenue by its carbon emissions or look at its reported energy intensity. Environmental issues are increasingly important to consumers and regulators. So choosing companies that are becoming more energy-efficient than their peers or moving towards eliminating carbon emissions might be desirable. 

Getting specific

Some metrics are specific to the type of business a company does. Banks make money by charging higher interest rates on loans compared to the interest they pay on deposits. Subtracting interest paid on deposits from income received from loans and dividing this by the total amount of loans made yields net income margin (NIM). A bank would like NIM to be as high as possible.

Analysing companies in the hotels business would not be complete without looking at revenue per available room (RevPAR). Average daily rate (ADR) and occupancy rate (OR) are also important and commonly reported by hoteliers. Multiplying ADR and OR together results in RevPAR. Obviously, charging more per night and/or fully booked rooms increases RevPAR. Expect to find substantial differences in RevPAR, ADR, and OR when comparing budget hotel operators against premium hoteliers.

Revenue per available seat kilometre (RASK) is important for looking at airline stocks and is calculated by dividing revenue by available seat kilometres (ASM). Multiplying the number of plane seats available by the number of kilometres they fly gives ASM. RASK will differ between budget airlines and flag carriers.

Picking winners

There is no single way to pick winning stocks. However, successful investors seem to strive to really understand the companies they invest in. Diving deep into an analysis of a company will help in understanding its strengths and weaknesses, and how it makes money. I have only scratched the surface here, but using alternative and industry-specific performance metrics should help an investor gain insight into a company.

Whatever the metric, noting it is higher or lower for one company versus another is not a reason to invest. Understanding it in terms of a competitive advantage that will persist might be a reason to pick one stock over another.

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James J. McCombie has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.