Last time, I wrote about the incredible returns an investor would have achieved when he or she exactly followed Greenblatt’s magic formula for investing (see here). We saw then that his magic formula was simply based on ranking companies by looking at how ‘good’ they are at earning money and how cheap they are when looking at their share price. This time I want to explain in more detail how to decide whether a company is ‘good’.
Greenblatt uses the Return on Capital (ROC) ratio to figure out how well a company is doing in generating profits. The ROC criterion gives a good indication of how well a specific company is performing, on a relative basis.
Imagine that as a private investor you get the choice of financing (just) one of the following companies. Which one would you prefer?
Company 1
Required capital $ 500.000
Earnings (EBIT) $ 35.000
Return on Capital: 7% (35.000 / 500.000)
Company 2
Required capital: $ 40.000
Earnings (EBIT): $ 20.000
Return on Capital: 50% (20.000 / 40.000)
Of course, you can – ceteris paribus – better start or finance a company with a high Return on Capital than a company with a low Return on Capital. High Return on Capital businesses are – on average – better than average. I write on average, because there are many factors that may lead to a high Return on Capital, for long as well as short periods of time. But, on average, companies with a high return on capital are special. After all, these organizations are somehow able to make more money than their competitors.
You may expect that the high ROC ratios of good, profitable companies will lower over time towards just an average ROC ratio (say 5 to 8%), because of the emergence of competing companies. However, this is not always the case. There are companies that, despite increasing competition, are able to generate above average ROC ratios, for many, many years. Let me explain a little bit more about the Return on Capital ratio.
More on the Return on Capital
You can calculate the Return on Capital ratio with the following formula:
Return on Capital = EBIT / (Net Working Capital + Fixed Assets)
EBIT: Earnings Before Interest and Taxes
Net Working Capital + Fixed Assets : Capital required for operating the business along with essential fixed assets (like buildings)
By using EBIT numbers instead of the more fickle reported earnings, companies can be compared in a more fair and comparable way. Financial management tricks, e.g. with respect to loans and/or taxes, only have a very limited influence on the reported EBIT numbers, but may strongly influence reported earnings. Therefore, I think Greenblatt made a smart choice when he decided to use EBIT numbers instead of reported earnings for his ranking system.
By simply dividing the EBIT number by the sum of net working capital and fixed assets, you will get a good notion of how profitable a company actually is. Because we are only looking at working capital, non-essential, excess cash for instance will not lower the calculated Return on Capital ‘undeservedly’. By the way, when calculating Return on Capital it also does not matter how a company is financed (by equity or by debt).
In sum, I think the Return on (invested) Capital ratio is a very useful indication of how well a company is performing on a relative basis and therefore gives a good indication of whether or not a company is ‘good’.
In my next article, I will explain what Greenblatt considers as cheap. After all, Greenblatt combines both the rankings on ‘good’ and ‘cheap’ to come up with his final ranking.
Greenblatt uses the Return on Capital (ROC) ratio to figure out how well a company is doing in generating profits. The ROC criterion gives a good indication of how well a specific company is performing, on a relative basis.
Imagine that as a private investor you get the choice of financing (just) one of the following companies. Which one would you prefer?
Company 1
Required capital $ 500.000
Earnings (EBIT) $ 35.000
Return on Capital: 7% (35.000 / 500.000)
Company 2
Required capital: $ 40.000
Earnings (EBIT): $ 20.000
Return on Capital: 50% (20.000 / 40.000)
Of course, you can – ceteris paribus – better start or finance a company with a high Return on Capital than a company with a low Return on Capital. High Return on Capital businesses are – on average – better than average. I write on average, because there are many factors that may lead to a high Return on Capital, for long as well as short periods of time. But, on average, companies with a high return on capital are special. After all, these organizations are somehow able to make more money than their competitors.
You may expect that the high ROC ratios of good, profitable companies will lower over time towards just an average ROC ratio (say 5 to 8%), because of the emergence of competing companies. However, this is not always the case. There are companies that, despite increasing competition, are able to generate above average ROC ratios, for many, many years. Let me explain a little bit more about the Return on Capital ratio.
More on the Return on Capital
You can calculate the Return on Capital ratio with the following formula:
Return on Capital = EBIT / (Net Working Capital + Fixed Assets)
EBIT: Earnings Before Interest and Taxes
Net Working Capital + Fixed Assets : Capital required for operating the business along with essential fixed assets (like buildings)
By using EBIT numbers instead of the more fickle reported earnings, companies can be compared in a more fair and comparable way. Financial management tricks, e.g. with respect to loans and/or taxes, only have a very limited influence on the reported EBIT numbers, but may strongly influence reported earnings. Therefore, I think Greenblatt made a smart choice when he decided to use EBIT numbers instead of reported earnings for his ranking system.
By simply dividing the EBIT number by the sum of net working capital and fixed assets, you will get a good notion of how profitable a company actually is. Because we are only looking at working capital, non-essential, excess cash for instance will not lower the calculated Return on Capital ‘undeservedly’. By the way, when calculating Return on Capital it also does not matter how a company is financed (by equity or by debt).
In sum, I think the Return on (invested) Capital ratio is a very useful indication of how well a company is performing on a relative basis and therefore gives a good indication of whether or not a company is ‘good’.
In my next article, I will explain what Greenblatt considers as cheap. After all, Greenblatt combines both the rankings on ‘good’ and ‘cheap’ to come up with his final ranking.
