The Mark of a Good Business: High Returns on Capital

Source: http://gregspeicher.com/

Joel Greenblatt’s Magic Formula looks for good companies that are available at a cheap price. To determine if a business is cheap, Greenblatt looks at the company’s earnings yield, which he calculates by dividing a company’s earnings before interest and taxes (EBIT) by the company’s enterprise value.

To determine if a prospective investment is a good business, Greenblatt looks at the company’s return on invested capital, which is very similar to the general approach taken by Buffett. However, the way Greenblatt calculates return on capital is different from Buffett. Greenblatt uses the ratio of EBIT to tangible capital employed.

Greenblatt uses EBIT instead of GAAP earnings so businesses with different tax rates and capital structures can be more easily and rationally compared. When calculating EBIT for the purpose of screening for Magic Formula stocks, Greenblatt makes the assumption that depreciation and amortization are equal to capital expenditures. This is done to simplify the calculations.

However, if you’re doing a more thorough analysis and not doing formula investing, it’s more accurate in lieu of EBIT to use the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) less maintenance capital expenditures. This approach gives a more accurate view of a business’s free cash flow and, by subtracting only maintenance capex, you can get a better look at the core business without taking into account capital that is being reinvested in the business for growth.

When looking at the Magic Formula, it is important to keep in mind that it is attempting to normalize different businesses so they can be compared on a level playing field. That way you can more clearly see which ones have superior economics, without the distortions that can come from the level of reinvestment in the business and the capital structure of the business.

Now let’s consider the denominator in Greenblatt’s equation for return on capital. As we saw in part 2 of this series, Buffett uses average equity employed by a business less goodwill and intangible assets as a proxy for the amount of capital the business is using. Goodwill and intangible assets are eliminated from the equation because, unless a business is going to grow in the future through acquisitions, the business will not need to pay a premium to reinvest earnings in order to grow organically.

Greenblatt goes farther than Buffett and only includes net working capital – current assets minus current liabilities – plus net fixed assets, which is called tangible capital employed. Greenblatt’s rational for using net working capital is that current liabilities functions as a kind of interest-free loan that reduces dollar for dollar the amount of capital needed to fund current assets. In addition to net working capital, he adds fixed assets because these are the long-term assets directly involved operationally in the generation of earnings and this is the area that will require additional capital to grow the business. It makes sense to see how productively these assets have been utilized on an historical basis.

I believe he leaves other long-term assets out of the equation not because they aren’t important in analyzing a business, but in order to again facilitate the comparison of different businesses so as to find those that are using their capital most productively.

For purposes of screening for Magic Formula stocks, based on the data provided by Greenblatt, this approach appears to successfully select cheap, good companies whose stocks outperform. Those doing active, focused investing will want to use this screen as a starting point for their own in-depth research.

All the tools we have looked at in this series are useful and should be part of your analytical toolkit. As I have stated before, no metric or ratio is a substitute for deeply understanding a business which only comes with thorough analysis and, typically, a good deal of work.

Disclaimer: This Blog, its owner, creator / contributor is not a research analyst and expressing opinion only as an individual investor in Indian equities. He/She is not responsible for any loss arising out of any information, post or opinion appearing on this blog. Investors are advised to consult financial consultant before acting on any such information. All information in this blog is posted for personal study, All information posted on blog is as available in public domain and for educational purpose.