Get an Edge With Reward/Risk

These scores are also sensitive to small changes in assumptions. In Ensco's case, if we lower the earnings growth forecast for the next five years to 10% from 11%, then reward/risk drops to 5.1 times from 5.4 times. Or, if share count stays flat for the next decade, then reward/risk improves to 6.0 times. So take these scores with a grain of salt. You do not need to know someone's weight to know he or she is overweight, and you do not need reward/risk in tenths to know the odds of success are in your favor.

Also, tangible book value may be an imperfect proxy of risk. For example, no credit is given to intangibles like brand names, patents and customer lists. If we account for these off-balance-sheet assets, then reward/risk scores for many "new economy" companies improve.

On the other hand, the more specialized a firm's tangible assets, the harder it may be to sell them in a crisis. In 1999, satellite phone operator Iridium went bankrupt less than a year after operations began. The system that cost Motorola (MOT Quote) $5 billion to build fetched just $25 million in bankruptcy. Tangible book value overstated Iridium's reward/risk score.

With this economy, you'll want to update your assumptions every few weeks. While updating my spreadsheet for this column, I noticed the consensus growth forecast for several companies in my portfolio fell. In some cases, reward/risk scores are now below 2.0 times, so I sold the stocks. Expect further downgrades ahead as we grind through this recession.

This was originally published on RealMoney on Dec. 24, 2008. For more information about subscribing to RealMoney, please click here.