Lesson 3 of 9
Choosing a guardrail
A guardrail is a figure, a direction and a level. Three tests decide whether a figure can carry one, before the level is even chosen.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
Who writes thisEditorial processLinkedIn (opens in a new tab)X (opens in a new tab)
In one minute
- A guardrail is a figure, a direction and a level. Most attention goes to the level, and most failures happen before it, in the choice of figure.
- The strict test: can the figure be rebuilt from an old filing using the exact formula the live figure uses today.
- An accounting standard can move a ratio with nothing about the business changing at all.
A guardrail is three things: a figure, a direction and a level. Three tests decide whether a figure can carry a condition at all. A figure that fails any of them still produces a guardrail, one that reports on something other than the business.
A figure that can be retro-tested against one that cannot
Can be rebuilt
- Current ratio, gross margin, return on equity: computed the same way from any old 10-K.
- Its ten-year path can be checked before you rely on it.
- Same formula is not the same basis: a new standard can still break the series (below).
Cannot be rebuilt
Return on invested capital, most scores
- The formula changed, or needs data an old filing does not carry the same way.
- You can set the condition. You cannot find out if it would ever have fired before.
Only the left side can be checked against history before it is trusted going forward.
Is it filed
A figure that depends on a price is not a statement about the business. It moves when the market's mood moves. In ValueScreener, price history is capped at five years by the vendor's plan while filed fundamentals run ten years or more back, because they come from SEC EDGAR rather than a quote feed. A condition on a filed figure rests on the deepest data in the system; a condition on a price rests on the shallowest.
Can it be rebuilt from an old filing
This is the strict test people skip. Eight figures pass it in ValueScreener: current ratio, debt to equity, free cash flow, gross margin, net margin, operating margin, one-year revenue growth and return on equity. Return on invested capital does not, and neither does the Piotroski F-Score. A condition set outside those eight cannot be checked backwards, which means there is no way to find out whether it is a test or an ornament.
Is it noisy
A figure that swings by a large fraction of itself every quarter for ordinary reasons will cross any level repeatedly and teach you to ignore it. A figure that has not moved in ten years will never cross anything. Print the company's own filed years before choosing, and look at the spread.
Annual or quarterly
An annual figure, from Item 8 of Form 10-K, is audited and slow: 60, 75 or 90 days after fiscal year end, by filer status. A quarterly figure, from Form 10-Q, is reviewed rather than audited and faster: 40 or 45 days. Compare a quarter with the same quarter a year earlier, never with the quarter before it: many businesses are seasonal, and the quarter before measures the calendar as much as the business. The fourth quarter has no filing of its own: its income and cash-flow figures are the year minus the three filed quarters.
A guardrail can fire on an accounting standard
ASC 842, Leases, put operating leases on the balance sheet for fiscal years beginning after 15 December 2018. Before it, the same obligation sat in a footnote. Nothing about any business changed on that date. Every ratio with assets or liabilities in it did.
Check yourself
What does it mean for a figure to pass the strict retro-test?
- It has a high value compared with other companies
- It can be rebuilt from a filing several years old, using the exact formula the live figure uses today
- It changes every quarter
Show the answer
Answer: B.
If a figure cannot be reconstructed backwards, there is no way to know whether a condition on it would ever have fired before.Why should a quarterly figure be compared with the same quarter a year earlier?
- Because quarterly filings are audited
- To remove seasonality, which the quarter before it does not do
- Because the fourth quarter has its own filing
Show the answer
Answer: B.
Comparing against the prior quarter measures the retail calendar as much as the business. The fourth quarter, in particular, has no filing of its own.What happened to the current ratio and debt to equity in the worked example, and why?
- The company took on new debt to fund expansion
- An accounting standard moved leases onto the balance sheet, with no new lease signed
- Earnings fell, pulling both ratios down
Show the answer
Answer: B.
ASC 842 recognised existing operating leases as a liability. The obligation was already there; only its presentation changed.Sources
- Form 10-K, General Instruction A(2): 60, 75 and 90 day filing deadlines.
- Form 10-Q, General Instruction A(1): 40 and 45 day filing deadlines.
- ASC 842, Leases, effective for public business entities in fiscal years beginning after 15 December 2018.
What this leaves out
- The eight retro-testable figures named here belong to one system. A reader working from filings alone can reconstruct anything they are willing to compute by hand.
- The filing deadlines quoted are outer bounds in the general instructions to the forms. A company can file earlier.
- The lease example is round invented arithmetic. The size of the effect at any real company depends on how much of its estate is leased.
- Nothing here is advice about any security.