December 18, 2008

Graham vs. Greenblatt (Session 4) Buy some cheap earnings

In our last post we looked at Greenblatt's use of Return on Capital as a means of identifying quality companies that know how to turn a small investment into a substantial return. In this posting we will look at his next criteria earnings yield.

What is it?

enterprise value

What does it tell us?

EBIT is defined as Earning before Interest and Tax, as we discussed in the last posting that works out to the raw income flowing into the company.

Enterprise Value is defined as market capitalization - cash and cash equivalents + preferred stock + debt

Market Capitalization is defined as the current number of outstanding stock multiplied by the current stock price.

So on the denominator what you have is the total of what it would cost to buy the company. To elaborate, if you bought the company outright you would have to buy all of the outstanding stocks + preferred stock + pay off all the current debt and only then could you access the cash reserves in the business.

Taking that into account what the ratio gives us then is an equation where you look at what percentage of the earnings you are buying if you paid for the company outright.

An example: the company has 1M stock outstanding at a current price of $4, they have no cash on hand (or units easily converted to cash) they do not have any preferred stock, and they have $1M in debt. This gives you a market capitalization of:

$4 *1M (stock) - $0 (Cash) + $0 (Preferred stock) + $1M (Debt) = $5M
So to buy the company outright would cost you approximately $5M

If the company in question raises $.5M per year in outright earnings you have an earnings yield of .5/5 or .1 or 10%. To put it another way if you took the $5M out of our pocket and bought the company it would take you 10 years to get the $5M back in your pocket again- assuming you are able to take the raw earnings directly.

What Greenblatt has done then is selected an alternative to Price Earnings Ratio to find companies with value.

So What Would Graham Think about these Rules?

As we stated in a previous post I can't imagine Graham would have been wild about using equations with Market Capitalization. Market Capitalization is a measure of how the investing community values the stock, it is an emotional assessment and is not a valuation of the actual bricks and mortar company itself.
Same as the last posting he might also be frustrated by the fact that this is one period- a company can always leap up and have one great period and then plunge back- it is called regression back to mean and it happens.

Be sure to check the previous parts in this series:

Part 1 Graham vs. Greenblatt (Session 1)
Part 2 Graham vs. Greenblatt (Session 2) Buy America Buy Big
Part 3 Graham vs. Greenblatt (Session 3) Buy Some Cheap Earnings