In Joel Greenblatt’s book The Little Book That Beats the Market, he taught a lesson about a magic formula that investors can use to chase higher market gains. That formula consisted of two distinct parts: earnings yield and return on capital.
This post will show you a practical example of how to find and calculate these metrics from a company’s annual report 10-k. There’s also a “2018 stock list” video at the bottom of this post where you can get an example of how to find stocks that fit Greenblatt’s magic formula criteria like this anytime you want in the future.
The place to find high ranking magic formula stocks is a website that Greenblatt owns himself called magic formula investing. One of the first stocks on that list is called Acuity Brands, since the list is curated in alphabetical order. We’ll use their 10-k financials as an example to teach you this valuable investing lesson.
Joel Greenblatt ran the hedge fund Gotham Capital from 1985 – 1995 for an annualized return of 50%. He wrote about this track record in his book, You Can Be ta Stock Market Genius, and shared his “magic formula” in his other book The Little Book that Beats the Market.
The basic premise of the magic formula is to combine a highly profitable and efficient company (and one that can quickly and easily grow), with a low valuation metric based on earnings. Picking only the best stocks that scored well in both areas, Greenblatt was able to produce outstanding returns for his investors and replicate similar results in numerous backtests.
More specifically, Greenblatt combined a high earnings yield with a high return on capital to pick only the stocks with seemingly the best chances for future success.
In addition to looking for stocks with a high earnings yield and return on capital, Greenblatt included the following criteria:
- Market capitalization > $50 million
- Avoid stocks from the utility and finance industry
- Invest only in U.S. stocks
- Buy 2- 3 of the highest scoring stocks each month, for 12 months
- Sell all positions after a one year holding period (selling losers before 365 days to utilize short term tax harvesting, selling winners after 365 days to get long term capital gains instead of short term)
The way Greenblatt defined earnings yield and return on capital (which are somewhat subjective measures) was as follows:
Earnings yield = EBIT / Enterprise Value
Return on Capital = EBIT / (net fixed assets + working capital)
Looking out at today’s market, Acuity Brands (AYI) currently scores high in both of the required metrics and is qualified based on market capitalization and industry/ location.
In a recent podcast episode we talked about the strengths of using both financial metrics in depth, which you can listen to (now or later) here:
Taking a look at $AYI’s recent 10-k (released October 2017) shows how these metrics score for the company currently.
- Net Sales = $3,505.1
- Cost of products sold = $2,023.9
- Gross profit = $1,481.2
- Operating proft = $518.8
- Total other expense = $26.2
- Income before provision for income taxes = $492.6
Note: All numbers in millions
So, based on this income statement the EBIT for AYI is $492.6 million. To calculate Earnings Yield, we must calculate the Enterprise value, defined as…
Enterprise value = Market capitalization + Debt (Long and short term) – Cash and Cash Equivalents
This is a somewhat simplified definition of enterprise value that still captures the essense behind its functionality, mainly that a company is penalized by having too much debt and rewarded for having large sums of cash. This is because the magic formula attempts to find higher Earnings Yield stocks, and so the lower the enterprise value, the higher the earnings yield.
Enterprise value tries to more accurately capture how the price at which the market is valuing the stock by also adding some business performance metrics such as debt and cash.
$AYI contains the following figures for those metrics:
- Market capitalization = $4.8 billion
- Current maturities of long-term debt = $ 0.4 million
- Long term debt = $356.5 million
- Total debt = $356.9 million
- Cash and cash equivalents = $311.1 million
Now, the calculations for enterprise value can vary from one valuation model to another based on some of the objectivity of the values.
For example, debt that publicly trades on the market (such as bonds) can be reasonably valued at a different carrying cost than is currently on the balance sheet and considered a better representation of the true value of the debt. Also like I said before, some definitions of the enterprise value formula can also include unfunded pension liabilities and metrics related to controlling interests. For the sake of this article and simplicity we are ignoring those.
The Enterprise value now becomes:
Enterprise value = 4,800 + 356.9 – 311.1
Enterprise value = $4,845.8 million
Taking the EBIT value above of $492.6 million, we get an earnings yield of the following:
Earnings yield = 492.6 / 4845.8 = 0.1017 or 10.17%
One other way to calculate the earnings yield (one that Joel Greenblatt doesn’t advocate) would be to take the inverse of the Price to Earnings ratio (or E/P). An Earnings Yield from that definition at 10.17% would be the same as a stock with a P/E of (1/0.1017 = 9.8).
So for those who aren’t familiar with whether 10.17% is a good figure for earnings yield or not, this gives you the P/E version equivalent of 9.8. Compare this to the true P/E of 15.3, and you can see that it seems like the debt and cash picture are indicating AYI’s true earnings power is being underrepresented in the market.
Now it’s time to do the Return on Capital formula. Since we already have the EBIT figure from before, we just need to find the net fixed assets and working capital. Net fixed assets is defined as Total Assets – Total current assets – Total Intangibles & goodwill. Working capital is simply current assets – current liabilities. (Note: All of the following numbers are in millions)
Net fixed assets
- Total Assets: $2899.6
- Total current assets: $1245.6
- Goodwill: $900.9
- Intangible Assets: $448.8
So, Net Fixed Assets = 2899.6 – 1245.6 – 900.9 – 448.8
Net Fixed Assets = $304.4 million
- Current Assets: $1245.6
- Current Liabilities: $600.9
And… Working Capital = 1245.6 – 600.9
Working Capital = $644.7 million
Now it’s time to bring this all back to the Return on Capital formula. Remember that Return on Capital = EBIT / [Net Fixed Assets + Working Capital].
$AYI Return on Capital = 492.6 / (304.4 + 644.7)
$AYI Return on Capital = 0.519, or 51.9%
Again, this is a very high value for a magic formula metric.
This stock definitely proves itself to score very high on Greenblatt’s magic formula for this year. It can make for an attractive stock purchase in the short term.
Whether that equates to a good long term holding will depend on how these metrics stack up over multiple years, and if they can continue or improve their excellent EBIT figures moving forward.
So now that you know how to source these numbers from a company’s 10-k to calculate the two components of the magic formula, you can start to invest like Greenblatt outlined in The Little Book That Beats the Market.
However, having a list of 30 stocks to sift through constantly (which is what’s available at magicformulainvesting.com) can be quite cumbersome and time consuming. To simplify the process, I made a video showing you how to quickly filter this list to research only the best stocks here: