Joel Greenblatt proposed a “magic formula” to rank stocks based on 2 factors: Return on Capital (ROC), and Earnings Yield. Each stock will be ranked based on each individual factor (hence each stock has 2 ranks), then we add the two ranks up, and perform a final sorting. Hence the best score a stock can achieve, is 2.
Return on Capital tells us how good a company is, and is defined as follows:
EBIT / (Net Working Capital + Net Fixed Assets)
- EBIT is used to allow us to view and compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels.
- It is assumed that depreciation and amortization expense (non-cash charges against earnings) are roughly equal to maintainance capex, hence it assumes that EBITDA – Maintenance capex = EBIT.
- The “capital” in this case is the tangible capital employed. The tangible capital employed tells us how much capital is actually needed to conduct the company’s business.
- ROA uses total assets, and ROE uses equity. Both total assets and equity values contain intangible assets and do not accurate reflect the amount of capital needed to do the business.
- Net Working Capital is used because a company has to fund its receivables and inventory (excess cash not needed to conduct the business is not included in the current assets). But it does not have to fork out the full current assets, because it gets what is effectively an “interest-free loan” in the form of account payables. So current liabilities needs to be subtracted from current assets (except for short-term interest-bearing debt, which is money that the company still needs to fork out since its not free).
- Net Fixed Assets (e.g. real estate, plant, equipment) is net of accumulated depreciation and additional capex.
- Intangibles, specifically goodwill, is not included because we want to use “tangible capital employed”. Goodwill does not need to be constantly replaced, hence in most cases, return on tangible capital alone (excluding goodwill) will be a more accurate reflection of a business’ return on capital going forward.
Earnings Yield tell us how cheap a company is, and is defined as follows;
EBIT / Enterprise Value
- Enterprise value = market value of equity (including preferred equity) + net interest-bearing debt
- Note that non-interest-bearing debt (such as accounts payable) is not included in the enterprise value calculation as those are essentially “free money”.
Joel then recommends to hold 20-30 top ranked stocks, and turn them over once a year. A historical study over 17 years showed very good performance of around 30% annually compounded returns.
- I am not sure why in the formula quoted in the book for Enterprise value, cash & cash equivalents (or excess cash) are not being subtracted. Not too sure whether or not that is intentional.
- I would think that NOPAT would be a better measure than EBIT, to take into account the differing tax rates. The tax rate, unlike the debt level, is something that a company has no control over. Hence even though two companies may have the same “fundamental earnings generation capability”, the effective tax rate might pick out the winner.
- We might need to include intangibles such as patents and such on top of the tangible capital employed, as these intangibles arise from R&D spending and needs to be constantly “replaced”. The way Greenblatt specifically singled out Goodwill as the intangible that needs to be excluded, and also that “in most cases, return on tangible capital excluding goodwill will be a more accurate ……..”, also implies that there are some intangibles that would need to be included.
- I’m not sure why “non-current, tangible assets” are not included in the calculation of the tangible capital employed. Are there any such assets apart from fixed assets (i.e. PP&E)? Wouldn’t it be easier and a better catch-all to use (total assets – intangibles – excess cash) – current liabilities (excl. interest-bearing debt) instead? or (total assets – goodwill – excess cash) – current liabilities (excl. interest-bearing debt) depending on the scenario.
[Quick Reference: Current assets include cash, accounts receivable, inventory, marketable securities, prepaid expenses. Current liabilities include accounts payable, short-term debt, accrued liabilities.]
- I just came across this interview of Joel Greenblatt by Forbes. In the interview, he highlighted that the magic formula is not applicable for Financials and Utilities, because EBIT does not make sense for Financials, and Utilities are regulated entities that have their returns being regulated.