# Earnings Yield and Return on Capital

I picked up a copy of Joel Greenblatt's "The Little Book that Beats the Market" today. In it, it talks about finding cheap companies (high earnings yield) and good companies (high return on capital).

The first time I saw a discussion on the importance of high earnings yield, is in Mary Buffett's Buffettology book (1st ed). At that time, I had a lingering thought that still persists today. The earnings yield is typically compared with the long-term US treasury "risk-free" rate, e.g. if a stock's earnings yield is 10% and the risk-free rate is 6%, then you're "earning more" with the stock, compared to what you're paying.

The thing that bothers me about this comparison is that for a bond, you are guaranteed your principal, whereas for a stock, if you decide to "redeem" that piece of ownership, the money you get is the market price at that time. With a loony stock market, that "market price" can range from zero to a whole lot. Hence with a non-guaranteed principal, there is not much point comparing the earnings yield of a stock to that of a bond (even if you make the 10%, you might lose all your principal). What this also means, is that the price that you pay initially, must be justified by all the future cashflows that comes in, so that even if the price of the stock ends up to be 0, you still get the future cashflows.

Turning next to Return on Capital (ROC), an example cited in Joel's book is that Jason spent \$400,000 to set up a store that ended up earning \$200,000, so ROC is 50%. Again, the fact that the principal (i.e. that \$400,000) must remain, is important. The ROC is 50% because we have (new value/old value) = 1.5, i.e. new value = \$400,000 + \$200,000 = \$600,000 and old value = \$400,000. Imagine, after spending \$400,000 for the store, if Jason wants to liquidate the store, he can only get back \$300,000. That would mean that (new value/old value) = (\$300,000 + \$200,000) / \$400,000 = 1.25, i.e. ROC = 25%.

That leads to an interesting problem, if the accounting books record NTA at cost, i.e. \$400,000, then we should do a bit of discounting at the numerator to get the ROC. If NTA is recorded at market value, then it would typically understate the cost and overstate the ROC. In that case, we need to find out how much was actually spent to generate that amount of earnings.