Company's Financial Accounting
Return on Capital, ROC
Magic Formula Investing of Joel Greenblatt
DEFINITION:
Return on Capital, ROC (Joel Greenblatt) is a metric that measures how efficiently the company generates returns on the capital actually invested in the business.
Joel Greenblatt is an American academic, investor, writer, hedge-fund manager, financial professional, value investing expert. He has presented an investment strategy of "Magic formula investing" in his book "The Little Book that Beats the Market". His formula, as has been found, really tends to beat in long-term the stock market's average annual returns. Magic Formula Investing is:
- procedure to find good companies to invest in;
- investment technique outlined by Joel Greenblatt where the principles of value investing are used;
- long-term investment strategy aimed to help investors buy good companies but only at a time when these companies are available at below-average prices;
- method of choosing stocks by ranking potential investments by two key criterions: earnings yield and return on capital;
- calculation based on finding companies that are undervalued by the market, where the main principle is the following: ideal company needs to be high quality, and it needs to be cheap
Thus, the main idea of the Magic Formula Investing is to invest in cheap stocks, which have a high return on capital (ROC) and high earnings yield (companies that are undervalued) with the aim to surpass the average market return. A high earnings yield means a cheap stock, whereas a low earnings yield indicates an expensive stock.
FORMULAS for calculations:
The formula for calculating ROC is the following:
But Greenblatt calculates the Return on Capital (ROC) using in his formula total value of the fixed assets (property, plant and equipment) and net working capital as denominator, instead of the more conventional sum of debt and equity. Also, he uses EBIT (earnings before interest and taxes) for the numerator instead of net income, because it allows to eliminate the distortions arising from differences in interest payments (debt) and taxes when comparing different companies.
Thus, ROC and Earnings yield (Joel Greenblatt) formulas:
WHERE:
- EBIT = Earnings Before Interest and Taxes
- Fixed Assets = non-current assets
- Net Working Capital = (Accounts Receivable + Total Inventories + Other Current Assets) - (Accounts Payable & Accrued Expense + Deferred Revenue + Other Current Liabilities)
In case of net working capital is negative, 0 can be used. - Enterprise value (EV) is used to value a company and calculated as Market Value + Debt – Cash:
Enterprise Value = Market Capitalization + Total Debt – Cash and Cash Equivalent
RESULT INTERPRETATION:
- High ROC and low price - is the main idea behind this strategy.
- Formula applies to large market capitalization stocks (companies with market capitalizations greater than $100 million).
- Formula doesn't include any small or micro-cap companies, non-U.S. companies, finance companies and utilities.
- Recommendation: Buy high quality companies that are undervalued.
- According to Greenblatt technique, it is advised to purchase about 20 - 30 "good companies": cheap stocks with a high earnings yield and a high return on capital.
- Rank companies by highest earnings yields and highest return on .
- Assessment and rank are made separately for return on capital and earnings yield: the company with the highest ROC gets 1 score, and the company with the highest earnings yield gets 1 score. Scores are to be summed to give a combined rank for the company. Companies with the lowest combined rank are recommended to buy.
- Re-balance portfolio have to be done once per year to choose the best companies.
- Greenblatt's formula associated with short-term underperformance in some periods and significantly increased volatility.