The Penke Scoring Model
When you look at a stock, it is easy to start with the price. I do the opposite. I first want you to understand the business behind that price, because that is what you are actually becoming an owner of.
I built the Penke Scoring Model to make that easier for you. I look at whether the business can survive, whether it is a good business, whether it is creating more value, what management does with the money, whether that value is actually reaching your share, and only then how demanding the valuation is.
The score helps me organize all of that for you, but I do not want you to blindly trust a number because I calculated it. I want you to understand why the number is there. My goal is that when you finish looking at a company with me, you can see the business much more clearly in your own head.
It starts with your money
My thinking is heavily influenced by Warren Buffett and Charlie Munger. The basic idea is actually very simple: when you invest your money in a company, you are giving up the chance to use that money somewhere else.
You could keep it. You could lend it through a bond. You could invest it in another company. You could spend it. So if you give your money to a business, there should be a good reason for doing that.
In the end, you want the business to turn the money you invest today into more value for you later.
That leaves us with three questions I want you to keep in your head:
- How much could you get back?
- When could you get it?
- How sure can you reasonably be?
Nobody knows the future, including me. But we can look at what the business has actually been doing and use that evidence to make a more informed judgment.
I do not want one quarter to fool you
One quarter can look amazing. The next quarter can look terrible. That does not always mean the whole business suddenly changed.
That is why I smooth many of the important business numbers with rolling 2-year, 5-year and 10-year moving averages. It helps you look through the short-term noise and see the bigger direction.
I learned this basic way of thinking from a trend approach called Consensio. It was originally used with price charts. I use the same idea on the business itself.
For example, if we are looking at free cash flow, I do not only ask whether it increased this quarter. I also want you to see whether the current result is above its 2-year, 5-year and 10-year normal, whether the shorter averages are above the longer ones, and whether those averages themselves are moving higher or lower.
When all of those views point in the same direction, you have much stronger evidence that something real is changing inside the company.
I show you how good it is, where it is going and how sure I am
A company can still be a very good business while slowly getting weaker. Another company can still be weak today while improving quickly.
I do not want to hide that difference inside one score. So when I look at a company for you, I separate three things.
Current strength
First I ask: how good is this part of the business right now?
Trend
Then I ask: is it getting stronger, getting weaker or staying roughly the same?
Confidence
Finally I ask: how sure am I about that direction?
If the 2-year, 5-year and 10-year trends all agree, I have much more confidence than when only the newest numbers have started improving.
I also look at how stable the business has been. If the results move smoothly from 100 to 105 to 110 to 115, I can understand that trend much better than when they jump from 100 to 30 to 180 to 40.
For you, that matters because a nice-looking growth number is much less useful when the business behind it is completely unpredictable.
The six things I want you to understand
1. Business Survival
Before we talk about growth or value, I first want to know whether the company can survive when things go wrong.
I look at the bills coming up soon, the resources available to pay them, the amount of debt and how easily the business can deal with that debt.
You can find the most exciting company in the world, but that does not help you much if a bad period can push it into serious financial trouble.
2. Business Quality
Next I want you to understand whether this is actually a good business.
Does it keep a healthy amount of its sales as profit? Does it earn a good return on the money and resources it needs to operate?
A company can grow very quickly while still being a poor business. If it constantly needs huge amounts of new money just to create a little extra profit, that growth is not nearly as attractive as it first looks.
So when I say a business is strong, I want you to know that I mean more than simply "sales went up."
3. Business Value
Here I want to show you whether the actual business is becoming more valuable over time.
Revenue tells us whether the company is getting bigger. Profit tells us whether that growth is useful. Free cash flow tells us whether the business is actually turning its success into cash. Book value helps us see whether value is building inside the company.
The important part is that these numbers should tell a story that makes sense together.
If sales are growing while profit and free cash flow are falling, I do not want to tell you that everything is great because revenue increased. I would rather tell you:
The company is getting bigger, but the business is not getting better at the same rate.
That gives you something useful to think about.
4. Capital Allocation
Once the business makes money, management has to decide what to do with it. This is one of the things I care about most.
Management can reinvest the money, buy another business, repay debt, buy back shares, pay you a dividend or simply keep the cash.
I do not automatically call one of those choices good or bad. I want to see what happened afterwards.
If management keeps $100 inside the company, I want you to ask: what did they turn that $100 into?
Did profit grow? Did free cash flow grow? Did the return on that money stay attractive? Did your share become more valuable?
If management can compound the money at a very attractive return, keeping it inside the business can be great for you. If they cannot find a good use for it, giving some of it back to you can make much more sense.
So I do not only show you where the money went. I try to show you whether management used it well.
5. Share Value
This is where I bring everything back to you.
You do not own the whole company. You own a share of it.
A company can grow enormously while issuing so many new shares that your own slice hardly improves. That is why I care so much about what happens per share.
I pay particular attention to free cash flow per share, earnings per share, book value per share and the number of shares outstanding.
Free cash flow per share is especially important to me because, in the end, I want to see the business producing more cash for every piece of the company you own.
If the whole company is growing but the value behind your individual share is not, I want you to see that.
6. Valuation Pressure
Only after we understand the business do I want to talk about valuation.
A fantastic company can still be a poor investment if everyone is already expecting perfection and you have to pay too much for those future results.
The opposite is true too. A cheap valuation does not suddenly turn a weak business into a wonderful one.
So I keep Valuation Pressure separate. I want you to understand the business first, and then look at how demanding the valuation is compared with the profit, cash, assets and growth behind your share.
Why I keep coming back to free cash flow
Profit is important, but ultimately I care about the cash a business can produce for its owners.
Free cash flow is the cash left after the company has paid the costs needed to run and maintain the business. That money can be reinvested, used to repay debt, used to buy back shares, paid to you as a dividend or kept for another opportunity.
That is why free cash flow, and especially free cash flow per share, is such an important part of how I look at a company.
But I still do not want you to look at free cash flow alone. I want revenue, profit, margins, returns on capital, book value and cash flow to tell a story that fits together.
How I estimate what the business could be worth
Once I understand the business, I try to answer a harder question for you: what could the future cash of this business be worth today?
I do not believe there is one perfect intrinsic value. The future is too uncertain for that. So I would rather give you a reasonable range and show you how I got there.
Step 1. I start with the cash the business can produce now
I start with current free cash flow per share and compare it with the recent 2-year normal. That stops one unusually strong or weak period from controlling the complete valuation.
I want the starting number to represent the business you own today, not the much smaller company it may have been five or ten years ago.
Step 2. I show you which way that cash is moving
Then I look at the 2-year, 5-year and 10-year moving averages.
If the current cash flow is above the 2-year average, the 2-year average is above the 5-year average, the 5-year average is above the 10-year average and all of those lines are rising, that tells you something important: the cash-generating ability of the business has been getting stronger across several timeframes.
Step 3. I check whether the rest of the company agrees
I do not want one strong cash-flow chart to fool you. I also check whether revenue, profit, margins, returns on capital, book value and the results per share support the same story.
If several important parts of the business are improving together, I have more confidence that the improvement is real.
Step 4. I ask how much of that growth could reasonably continue
This is where I deliberately become more careful for you.
A small company can double much more easily than an enormous company. Growing from 1 to 2 requires one extra unit. Growing from 100 to 200 requires another 100.
The percentage is exactly the same, but the amount of extra business needed is completely different.
So even when the trend is extremely strong, I do not simply assume that the same percentage growth will continue forever.
Step 5. I let high growth slow as the business becomes bigger
If a company is growing quickly, I gradually reduce that growth as I look further into the future.
If the 2-year, 5-year and 10-year evidence all agrees, I may have more confidence in stronger growth at the beginning. But even great companies eventually need more and more additional sales, profit and cash just to maintain the same percentage growth.
Step 6. I estimate the cash your share could produce later
I then project what free cash flow per share could look like over the coming years.
I do not want you to see that as a prediction. It is a scenario based on what the business is showing us today.
Step 7. I bring that future money back to today
If somebody offers you $100 today or $100 ten years from now, those two amounts are not worth the same to you.
You can use today's money in the meantime. You could lend it through a relatively safe bond or invest it somewhere else.
So when I value future cash, I require a return for waiting and for taking the risk that the future may not turn out the way we expect.
Step 8. I remember that the business still exists afterwards
My forecast might stop after a number of years, but the company hopefully does not.
So I also estimate what the cash-producing business could still be worth after the years I explicitly calculate.
Step 9. I give you a range
Finally I bring all of those future cash flows back to today's value.
That gives me a range I can keep in my head when I look at the business. I would much rather tell you that my reasonable range is, for example, $130 to $180 than pretend I somehow know the company is worth exactly $154.37.
Why I also show you book value
I want you to know what sits behind your share too, so I also show you book value per share.
But I normally do not simply add book value on top of the cash-flow valuation. The assets inside the company are usually part of what allows the business to produce those future cash flows. Adding both together can mean counting some of the same value twice.
So I show book value as another way for you to look at the company. For an asset-heavy business it can be extremely important. For another business, its ability to generate cash may matter much more.
Improving does not automatically mean good
This is one of the distinctions I really want you to understand.
Imagine a company that has been losing money for years. Its 10-year normal is -$20 million, its 5-year normal is -$15 million, its 2-year normal is -$10 million and it now loses only -$5 million.
That company is clearly improving. I want you to see that because, if the trend continues, the business may look very different in the future.
But it is still losing money today.
So instead of pretending it is already a great business, I might tell you:
Still weak, but improving strongly.
Now you know both things.
A great business can be weakening too
The opposite can happen. A company can still earn excellent returns, produce lots of cash and have a strong balance sheet while the recent trends are slowly starting to move the wrong way.
I do not want you to suddenly call that company bad. But I do want you to notice the change.
So I might tell you:
Still very strong, but slowly weakening.
That tells you far more than watching a score move from 86 to 81.
So what does the Penke Score mean?
The Penke Score is my shortcut through all of this information.
It is not me telling you to buy. It is not me telling you to sell. And it is definitely not a prediction of what the stock price will do tomorrow.
I use the score to help you quickly see the overall business picture. Then I show you the pillars, the trends, my confidence and the actual numbers behind it so you can understand why.
The explanation matters more than the number.
I want you to understand what you own
I do not want Penke Investing to become another website where you see a green number and blindly follow it.
I want you to come here and understand why a business looks strong, why it looks weak, what is changing and what those changes could mean for you later.
That can help you when you are looking for a new company. But I think it becomes even more useful when you already own the stock.
If the stock suddenly falls 20% because of a headline, you can come back here and ask yourself: did the actual business change? Did cash generation change? Did profitability change? Did debt become more dangerous? Is management still using the money well? Is the value behind my share still improving?
If the business did not change much, that gives you a very different picture from simply staring at a falling stock price.
The more companies you study this way, the easier these connections become to see. What you learn from one company helps you understand the next one.
Your knowledge compounds too.
That is what I want Penke to do for you: help you understand what you own, see what is changing inside the business and give you a clearer basis to make your own decision with your own money.