By Joel Greenblatt.
In his book, Greenblatt presents a “Magic Formula” for buying good companies at good prices. These concepts – good company and good price – are represented by two ratios from companies’ financial statements:
Return on Invested Capital (ROIC) represents “good company”
& Earnings Yield represents “good price".
Here is the technical definition of both ratios, plus a quick way to think about them:
Return on Invested Capital (ROIC) = (Earnings Before Interest & Taxes + Depreciation – CapEx) / (Net Working Capital + Net Fixed Assets)
This tells you how much cash a company generates in relation to the amount of capital tied up in its business. As ROIC numbers increase, all else being equal, a business gets better and better. The reason is that when you own a business, the higher your ROIC, the more money you are able to pocket every year in relation to the money you have invested in the business.
Earnings Yield = (Earnings Before Interest & Taxes + Depreciation – CapEx) / Enterprise Value (Market Value + Debt – Cash)
This tells you how expensive a company is in relation to the earnings the company generates. When looking at Earnings Yield, we make certain adjustments to a company’s market capitalization to estimate what it would take to buy the entire company. This involves penalizing companies that have a lot of debt and rewarding others that have a lot of cash.
Greenblatt’s Magic Formula gives these two ratios equal weight when selecting investments. The Formula ranks all companies in the investable universe by Good Company (ROIC) and also by Good Price (Earnings Yield). Then, each company’s ROIC and Earnings Yield ranks are added together. Greenblatt’s Formula has an investor buy companies with the best combined rankings, hold each company for a year, and then move funds into new highly ranked companies. This approach is sound and simple enough that when someone wants to learn about investing or is considering managing his own equity portfolio, we strongly encourage him to read Greenblatt’s book.