The Secret to Buffett-style Investing: Unlocking the Power of High Returns on Capital Part 3

Investment guru Joel Greenblatt has a formula for finding great companies at a bargain price. It's called the "Magic Formula" and it's based on two key metrics: earnings yield and return on invested capital. To determine if a company is cheap, Greenblatt looks at its earnings yield, which he calculates by dividing a company's earnings before interest and taxes (EBIT) by its enterprise value. To determine if a company is a good business, he looks at its return on invested capital, which is similar to the approach used by Warren Buffett. Greenblatt uses EBIT instead of GAAP earnings to make it easier to compare businesses with different tax rates and capital structures. He also makes the assumption that depreciation and amortization are equal to capital expenditures in order to simplify the calculations. However, if you're doing a more thorough analysis, it's more accurate to use the company's earnings before interest, taxes, depreciation, and amortization (EBITDA) less maintenance capital expenditures. This approach gives a better view of a business's free cash flow and shows how much of the core business's earnings are being reinvested for growth. When looking at the Magic Formula, it's important to keep in mind that it is trying to normalize different businesses so they can be compared on a level playing field. This way, you can more clearly see which businesses have superior economics without the distortions that can come from the level of reinvestment in the business and the capital structure of the business. In terms of the denominator in Greenblatt's return on capital equation, he uses net working capital (current assets minus current liabilities) plus net fixed assets, also known as tangible capital employed. This is more restrictive than the approach used by Buffett, who uses average equity employed by a business less goodwill and intangible assets. Greenblatt's rationale for using net working capital is that current liabilities function as a kind of interest-free loan that reduces the amount of capital needed to fund current assets. He also adds fixed assets because these are the long-term assets that are directly involved in generating earnings and require additional capital to grow the business. The Magic Formula is a useful tool for screening for great companies at a cheap price, but it's important to remember that it is only a starting point for your own research. No metric or ratio is a substitute for deeply understanding a business, which comes with thorough analysis and hard work.