What Are Soft Metrics?
In finance, the term “soft metrics” is used to describe indicators related to the value or performance of a company which deviate from traditional “hard” metrics such as net profit margins or earnings per share (EPS).
Soft metrics are typically used when hard metrics are difficult to obtain. During periods of irrational exuberance, such as the dotcom bubble that occurred in the late-1990s, investors will often point to soft metrics to justify a company’s valuation. In those instances, the companies’ valuations would typically not be justified on the basis of hard metrics.
- Soft metrics are non-traditional measures used to assess the performance of a company.
- They are typically designed at the discretion of the company or analyst in question, and can therefore prove difficult to independently verify.
- Some investors will be reluctant to trust soft metrics due to the ease with which they can be manipulated to produce desired results.
Understanding Soft Metrics
Because they are intended to be flexible and tailored to the company at hand, there are a wide variety of potential soft metrics. Indeed, because soft metrics are not standardized and fall outside the strictures of Generally Accepted Accounting Practices (GAAP), analysts are free to develop new soft metrics as needed.
Nevertheless, what most soft metrics have in common is that they seek to evaluate characteristics about a company that are deemed important despite not appearing directly on the financial statements. For example, an Internet-based company might report its web traffic trends as a soft metric, arguing that they will be able to monetize this popularity in the future despite not showing profitability today. In this scenario, the company is arguing that the soft metric is an important forward-looking indicator, providing evidence that the company’s business model is fundamentally sound.
From the investors’ perspective, it is important to treat soft metrics with a healthy dose of skepticism. After all, because they are not subject to clear guidelines and audits, there is considerable room for companies to engineer their soft metrics in such a way as to produce a desired result. This is particularly true when the metric in question relies on complex calculations requiring multiple assumptions. In those scenarios, even a minute change in assumptions could have a large effect on the results. And because the company may not be required to disclose the nature of those assumptions, investors may have no means of independently verifying the reasonableness of the figures presented.
Real World Example of Soft Metrics
XYZ Corporation is a promising startup that recently completed its second round of fundraising. The new investors were particularly impressed by the steady progress made in XYZ’s product development efforts, which XYZ demonstrated through a variety of soft metrics.
Although the new fundraising round was generally seen as a success, one of the venture capitalist (VC) firms that participated in the very first round of fundraising was noticeably absent from the second round, instead choosing to sell their position to another VC firm.
When asked why they chose to exit their position, the VC firm responded that they were unconvinced by the progress being claimed by XYZ on the grounds that the company did not provide them with a detailed explanation for how their soft metrics were calculated. In the absence of any hard metrics to verify XYZ’s progress, the VC firm did not feel comfortable proceeding as backers of the firm.