What Does RBP Probability Tell Us?

RBP Probability tells us the likelihood, based on historical rates of sales growth, that a company will be able to generate sufficient sales to justify the current price of its stock. So how do we use this?

The best way is to use it to assess the riskiness of a stock at its current price. Investors have always had a hard time quantifying the risk inherent in investing in stocks. (For that matter, people have had a hard time quantifying any type of risk.) We used to have beta, the relative volatility of a stock relative to the volatility of the market. This made some amount of sense for the short-term trader who may have to liquidate at a moment’s notice. If the stock is very volatile, and the trader happens to be forced to sell when the stock is down, well, that is bad. And thus volatility makes the purchase of the stock risky.

But for the long-term investor beta makes little sense as a measure of risk because long term investors have the luxury of not concerning themselves with how much the stock price wiggles around throughout the course of their holding. As long as the trend is up and the investor has a decent size window in which to liquidate his holding, then daily, weekly or even monthly volatility does not matter. Moreover, an underlying assumption in finance is that risk is rewarded by higher expected returns. So regardless of how you define risk, if you assume risk you should expect the possibility of earning large returns. This is where beta fails explicitly, because the empirical evidence has shown little relationship between beta and subsequent returns.

Warren Buffett has often cited the Washington Post Company (WPO) at the time of his investment in it in 1973 as an example of the foolishness of the use of beta as a measure of risk. When Buffett invested in the company it had just come off a large price decline. Because of the movement of the market over the same period, this made the company’s beta very high. How can it be, Buffett argues, that the stock was a riskier investment at $23/share than it was six months earlier at $37/share? Does buy-low-sell-high not apply?

Of course, the distinction is that Buffett is concerned with fundamentals, whereas the calculation of beta (and much of academia) does not concern itself with fundamentals. This is logical if the market efficiently prices stocks and all public information is impounded into stock prices (another working assumption in most academic work) since fundamentals do not matter.

But this is really pretty absurd. Fundamentals are all that matters on a business level, where the aim of management is to generate income and maximize value. So perhaps the appropriate approach to quantifying risk is to do so on the basis of business performance AND price paid. This is what RBP Probability does. If stock price declines, the company’s Required Business Performance declines as well, making it more likely that the company can meet this level of performance. RBP Probability will increase, and thus, the stock is less risky at the new, lower price – just as Warren Buffett observed that the Washington Post was less risky at $23 than it was at $37.

RBP Probability is calculated by comparing the company’s Required Business Performance to a distribution of past sales growth. The Required Business Performance will imply a certain level of sales growth, so the RBP Probability is determined where in the distribution of past sales growth this implied level of sales growth falls. This makes the procedure entirely objective in the sense that past sales numbers are known unambiguously and where the sales growth implied by the Required Business Performance falls within this distribution is not subject to analyst discretion.

To me, it makes a lot more sense to assess the riskiness of the stock by determining how appropriate – how justified – the current price is. If business performance falls, so too does RBP Probability. If stock price increases, RBP Probability falls. The relationships between risk and stock characteristics that seem the most intuitive are all accounted for.