In my previous article I showed that value investor Joel Greenblatt, with his magic formula, ranked stocks (read companies) on two factors: how good a specific company is in earning money and how cheap a specific companies shares are. In the article, we focussed on how to decide whether a company is good. This time, I want to focus on what Greenblatt considers as a (relatively) cheap company.
However, first I would like to explain a little bit more about the system behind the magic formula of Greenblatt. The system starts by ranking the biggest 3500 stocks on how cheap they are. The cheapest stock of all gets ranking number 1, the most expensive one (probably of a company losing a lot of money) gets ranking number 3500. A stock ranked e.g. 284 gets number 284.
Then, Greenblatt makes another, similar ranking, by looking at how good the same 3500 selected companies are in simply earning lots of money. The best company gets number 1, a stock ranked e.g. 415 gets number 415, etc.
In the next step, Greenblatt combines both rankings for all 3500 stocks. A company that ranks 146 on cheapness and 312 when looking at the ‘good’ factor gets a combined score of 458 (146 + 312). Greenblatt uses these (combined) scores for his final ranking (the lower score, the more attractive a stock generally is). And it is this final ranking that formed the basis of the incredible returns as described in my first article about Greenblatts magic formula!
Something more about the factor ‘cheap’
The ratio Greenblatt uses to determine if a company is relatively cheap is the Earnings Yield. This ratio can roughly be seen as the inverse of the more commonly known Price/Earnings ratio (P/E)
Let me further explain this with a (simplified) example: A P/E ratio of 20 leads to an Earnings Yield of 5% (100/20). And a P/E of 10 is the same as an Earnings Yield of 10% (100/10). Other things being equal, we can say that it is smarter to buy stocks that are cheap (stock that have a high Earnings Yield) instead of buying expensive stocks (with low Earnings Yields). Yes, I know, it’s common sense, but not common practice!
Choosing the optimal savings account is a similar process: you would normally prefer an account with a high interest rate (c.f. high Earnings Yield) over one with a low interest rate (c.f. low Earnings Yield). So, smart value investors like Joel Greenblatt generally prefer stocks with high Earnings Yields just like most of us prefer savings accounts with high interest rates.
How to calculate the Earnings Yield
You can calculate the Earnings Yield with the following formula:
Earnings Yield = EBIT / Enterprise Value
EBIT: Earnings Before Interest and Taxes
Enterprise value: Market Capitalization + Total Debt – Cash
As we have seen before, you can compare companies in a more fair and comparable way when using EBIT numbers instead of the more volatile reported earnings. Financial management tricks, e.g. with respect to taxes and/or loans, only have a very limited influence on the reported EBIT numbers, but may strongly influence reported earnings.
The usage of Enterprise Value instead of merely the price of equity (i.e. total market capitalization) looks like a smart choice to us. That’s because, by correcting for debt and cash, you’ll get a better idea of the relative valuation of a company. Consequently, you can make a fairer comparison of the cheapness of different companies than someone who only looks at P/E-ratios.
However, first I would like to explain a little bit more about the system behind the magic formula of Greenblatt. The system starts by ranking the biggest 3500 stocks on how cheap they are. The cheapest stock of all gets ranking number 1, the most expensive one (probably of a company losing a lot of money) gets ranking number 3500. A stock ranked e.g. 284 gets number 284.
Then, Greenblatt makes another, similar ranking, by looking at how good the same 3500 selected companies are in simply earning lots of money. The best company gets number 1, a stock ranked e.g. 415 gets number 415, etc.
In the next step, Greenblatt combines both rankings for all 3500 stocks. A company that ranks 146 on cheapness and 312 when looking at the ‘good’ factor gets a combined score of 458 (146 + 312). Greenblatt uses these (combined) scores for his final ranking (the lower score, the more attractive a stock generally is). And it is this final ranking that formed the basis of the incredible returns as described in my first article about Greenblatts magic formula!
Something more about the factor ‘cheap’
The ratio Greenblatt uses to determine if a company is relatively cheap is the Earnings Yield. This ratio can roughly be seen as the inverse of the more commonly known Price/Earnings ratio (P/E)
Let me further explain this with a (simplified) example: A P/E ratio of 20 leads to an Earnings Yield of 5% (100/20). And a P/E of 10 is the same as an Earnings Yield of 10% (100/10). Other things being equal, we can say that it is smarter to buy stocks that are cheap (stock that have a high Earnings Yield) instead of buying expensive stocks (with low Earnings Yields). Yes, I know, it’s common sense, but not common practice!
Choosing the optimal savings account is a similar process: you would normally prefer an account with a high interest rate (c.f. high Earnings Yield) over one with a low interest rate (c.f. low Earnings Yield). So, smart value investors like Joel Greenblatt generally prefer stocks with high Earnings Yields just like most of us prefer savings accounts with high interest rates.
How to calculate the Earnings Yield
You can calculate the Earnings Yield with the following formula:
Earnings Yield = EBIT / Enterprise Value
EBIT: Earnings Before Interest and Taxes
Enterprise value: Market Capitalization + Total Debt – Cash
As we have seen before, you can compare companies in a more fair and comparable way when using EBIT numbers instead of the more volatile reported earnings. Financial management tricks, e.g. with respect to taxes and/or loans, only have a very limited influence on the reported EBIT numbers, but may strongly influence reported earnings.
The usage of Enterprise Value instead of merely the price of equity (i.e. total market capitalization) looks like a smart choice to us. That’s because, by correcting for debt and cash, you’ll get a better idea of the relative valuation of a company. Consequently, you can make a fairer comparison of the cheapness of different companies than someone who only looks at P/E-ratios.
