The GuruFocus site gathers together a wide variety of information and calculations that investors can use to help determine whether or not investing in a specific stock is the right choice for them.
Among these calculations are Joel Greenblatt (Trades, Portfolio)’s earnings yield and return on capital, which he introduced as part of his “Magic Formula” when he published his 2005 book, “The Little Book That Beats the Market.” The idea behind the Magic Formula is to apply a simple mathematical formula to find profitable businesses that trade at bargain prices. The formula ranks companies based on the combination of earnings yield and return on capital.
Earnings yield
The earnings yield, which Greenblatt defines as earnings before interest and taxes (Ebit) divided by enterprise value, measures how much the company earns compared to how much it costs to purchase the stock.
When introducing earnings yield in his book, Greenblatt first used a more simplistic approach when explaining how the metric worked. Providing the hypothetical example of Jason’s Gum Shops, in which an enterprising child buys packs of gum and resells it by the stick for a higher price, Greenblatt imagines what would happen if such a “company” went public. With 1 million shares priced at $12 apiece, if the company brought in earnings of $1.2 million for the year, then the earnings yield (calculated by dividing earnings per share by the share price) would be 10%. The more the company earns per share, the higher its earnings yield, and thus the more attractive an investment the company is.
After explaining the basic concept of earnings yield, Greenblatt then described his reasoning for using Ebit divided by enterprise value rather than the more traditional earnings per share to share price ratio:
“Enterprise value was used instead of merely the price of equity (i.e., total market capitalization, share price multiplied by shares outstanding) because enterprise value takes into account both the price paid for an equity stake in a business as well as the debt financing used by a company to help generate operating earnings. By using EBIT… we can calculate the pre-tax earnings yield on the full purchase price of a business (i.e., pre-tax operating earnings relative to the price of equity plus any debt assumed).”
The advantage of this calculation is that it puts companies with different levels of debt and different tax rates on an equal footing, giving a better idea of how much a business earns relative to the true expenses of purchasing its stock.
Return on capital
The return on capital, which Greenblatt defines as Ebit divided by the sum of net fixed assets and net working capital, measures how much a company earns compared to what it spends to produce those earnings.
Returning to his example of Jason’s Gum Shops, Greenblatt imagines a scenario where each store in the chain of gum shops costs $400,000 to build. Over the course of a year, each gum shop brings in earnings of $200,000. Such a scenario would result in a yearly return, also known as return on capital, of 50%. Naturally, the more earnings a company brings in relative to the costs of building the necessary facilities to generate those earnings, the more attractive the business is from an investing standpoint.
When defining his own version of the return on capital calculation, Greenblatt selected Ebit divided by the sum of net fixed assets and net working capital due to the following reasons:
“Net Working Capital + Net Fixed Assets (or tangible capital employed) was used in place of total assets (used in an ROA calculation) or equity (used in an ROE calculation). The idea here was to figure out how much capital is actually needed to conduct the company’s business. Net working capital was used because a company has to fund its receivables and inventory (excess cash not needed to conduct the business was excluded from this calculation) but does not have to lay out money for its payables… In addition to working capital requirements, a company must also fund the purchase of fixed assets necessary to conduct its business.”
Greenblatt’s calculation aims to exclude intangible assets such as goodwill. The difference between reported equity and assets and tangible equity and assets can cause inaccurate distortions in calculations. Distortions can also occur due to differing tax rates and debt levels. Thus, Greenblatt holds that in most cases, return on tangible capital alone (excluding goodwill) is a more accurate reflection of a business’ prospects.
Uses and pitfalls
Individually, earnings yield can be used as a measurement of a company’s profitability relative to its stock price, while return on capital can evaluate how efficiently a company generates returns on the capital invested in the business.
On the GuruFocus stock summary pages, the return on capital can be found in the “profitability” section, while the earnings yield appears in the “valuation & return” section:
Both of these metrics have a drawback in that they do not consider the growth of the company. They take a snapshot of the company’s performance during a specified period of time, neither dwelling on the distant past nor speculating about how the situation might change in the future.
Greenblatt’s earnings yield and return on capital are most commonly used together as the foundation of his Magic Formula. GuruFocus’ Magic Formula screener, which is based on Greenblatt’s formula, ranks stocks based on the combination of these two metrics.
According to Greenblatt’s case studies, the Magic Formula works best when applied to U.S. companies and companies with market caps of at least $100 million, so he excludes companies that do not meet these criteria. He also eliminates utilities and financial companies for similar reasons. Investors can apply these additional criteria to GuruFocus’ Magic Formula screener if they wish.
The Magic Formula is meant to be a quantitative, methodical and unemotional approach to investing. More often than not, back-testing studies have shown that this approach can be highly successful in beating the market.
As with any quantitative stock-picking method, the Magic Formula does not account for a range of extenuating circumstances that may skew results. One issue that has come up in recent years is that tech and biotech startups that are generating no earnings of their own will sometimes appear high up on the Magic Formula screener due to their large market caps and floods of cash to fund their research. To help eliminate such extenuating circumstances, it can be helpful to raise the bar on the minimum market cap, look for positive Ebitda growth rates or manually exclude exceptional cases.
