| As adherents to Joel Greenblatt's Magic Formula | | | | subtract out liabilities. However, it can present a |
| Investing strategy know, the formula boils investing | | | | skewed picture for firms with a lot of debt. For |
| down to two simple statistics: earnings yield and | | | | example, check printer Deluxe (DLX) has a return on |
| return on capital. Earnings yield is a measure of how | | | | equity that looks outstanding at 175%, until you |
| cheap a company is against it's profits. Return on | | | | realize that the company has a nearly $900 million |
| capital is a measure of how efficiently a company | | | | debt load, leaving just $65 million in equity! |
| employs it's resources to generate those profits. | | | | Return on capital solves these problems. It counts |
| When you put them together, they are the tangible | | | | only assets and liabilities that are employed in |
| statistics behind the simple strategy of buying good | | | | generating operating earnings, and removes the rest. |
| businesses (high return on capital) at low prices (high | | | | Non-operating costs and profits, such as interest and |
| earnings yield). | | | | equity investments, are removed to get a more clear |
| In this article, we will dive more into the return on | | | | picture of the business itself. The equation for |
| capital figure and examine its importance and how it | | | | calculating traditional invested capital is: |
| is calculated. So, what exactly does return on capital | | | | Return on Invested Capital (ROIC) = (Operating |
| tell us? For most investors, an analogy may be the | | | | Earnings * (1 - Tax Rate)) / Invested Capital |
| most apt way to grasp the meaning. Imagine you are | | | | Invested Capital = (Total Assets - Excess Cash - |
| an investor shopping for a mutual fund in which to | | | | Interest Bearing Assets) - (Short-term Liabilities + |
| park your money. Since you are investing for the | | | | Interest Bearing ST Liabilities) |
| long term, you leaf through prospectuses looking at | | | | To illustrate an ROIC calculation, we'll use an example, |
| the 10-year average return. Fund manager A has | | | | Intel (INTC): |
| managed to deliver 15% annual gains to his investors, | | | | Total Assets = 55,651 |
| while fund manager B has delivered just 5%. Clearly, | | | | Excess Cash = 12,797 |
| your money would have grown faster by being with | | | | Interest Bearing Assets = 987 (Equity Securities) + |
| fund manager A, as he would have better allocated | | | | 4,398 (Other LT Investments) = 5,385 |
| your dollars to achieve wealth. | | | | Short-term Liabilities = 8,571 |
| The concept is no different in business. Management | | | | Interest Bearing ST Liabilities = 142 (Short-term debt) |
| has to decide how to allocate their capital, including | | | | Invested Capital = (55,651 - 12,797 - 5,385) - (8,571 + |
| equity capital (earned through the issuance of shares | | | | 142) = 28,898 |
| to the public), debt capital (acquired through bond | | | | Intel earned $8.732 billion in operating earnings, and |
| issuance or bank loans), and operating earnings | | | | paid a tax rate of about 23.9%. Therefore, ROIC |
| (earned through operations). The decision has to be | | | | would be: |
| made - do I spend to grow sales organically, for | | | | ROIC = (8,732 * (1 - 0.239)) / 28,898 = 0.230 or |
| example by spending on product development or | | | | 23% |
| new sales territories? Or do I pay to acquire new | | | | Clearly, 23% is a very good return on capital. Most |
| business lines? Or are growth opportunities limited | | | | investors would be quite pleased with an investment |
| and acquisitions overpriced enough that I should just | | | | that earned that kind of return annually! |
| sit on my cash or pay it back to shareholders? These | | | | Now, the Magic Formula strategy as devised by |
| decisions are at the core of senior management, and | | | | Greenblatt uses a slightly different calculation. First, it |
| the effectiveness of these decisions are reflected in | | | | differs in calculating Invested Capital. Difficult to value |
| the return on capital number. A business with a higher | | | | assets like goodwill (the amount paid over book value |
| return on capital, like a mutual fund with a great | | | | for acquisitions) and intangible assets (like brands, |
| manager, will deliver more wealth to its shareholders | | | | patents, and so on) are removed, as different |
| over the long term. | | | | companies may use different accounting assumptions |
| So, how is it calculated? First, there are several ways | | | | for these. Also, the tax rate is removed from the |
| to measure it. The simplest and most widely available | | | | ROIC calculation, as some industries have the ability |
| are return on assets (ROA) and return on equity | | | | to manufacture favorable tax conditions. By removing |
| (ROE). The return on assets equation measures the | | | | them, a more comparable figure is created, although |
| profit earned on each dollar of raw assets (buildings, | | | | the actual meaning of that figure is somewhat |
| cash, equipment, inventory, and so forth). The | | | | diminished. In practice, an MFI return on capital figure |
| calculation here is: | | | | north of 40% is pretty good. For Intel, calculating MFI |
| Return on assets = Net Income / Total Assets | | | | invested capital looks like this: |
| Return on equity is the profit earned on each dollar | | | | MFI Invested Capital = Invested Capital - Goodwill - |
| of equity capital - in essence, each dollar you own of | | | | Intangible Assets |
| the company. This is a bit more meaningful because it | | | | = 28,898 - 3,916 (Goodwill) = 24,982 |
| takes a firm's liabilities and debt into account and | | | | MFI ROIC = Operating Earnings / MFI Invested |
| gives a better estimate of what net capital actually is. | | | | Capital |
| The calculation here: | | | | = 8,732 / 24,982 = 34.9% |
| Return on equity = Net Income / Total Equity | | | | 35% Magic Formula return on capital is good, but not |
| There are problems with each of these measures, | | | | outstanding. However, the fact that Intel's traditional |
| however. Return on assets is a useful equation for | | | | ROIC is so high is additional evidence that it is an |
| comparing firms within the same industry; for | | | | exceptional business. For it to be a Magic Formula |
| example, comparing Pfizer (PFE) against Merck (MRK). | | | | stock, the earnings yield hurdle would be set higher. |
| However, it is usually not useful for comparing firms | | | | Also, Intel has been able to maintain high returns on |
| in different industries with different capital | | | | capital over a long period of time, evidence of a |
| requirements, and it also does not take into account | | | | competitive moat. |
| what assets are actually employed in generating | | | | Return on capital is a most important measure of the |
| profits and which are "extra". Return on equity, on | | | | efficiency of a business and should be an important |
| the other hand, is somewhat better as it does | | | | tool for stock investors, Magic Formula or otherwise. |