December 17, 2008

Graham vs. Greenblatt (Session 3) Return on Capital

Greenblatt in his book The Little Book that Beats the Market advocated a simple method for attaining substantial stock returns. In this series we are looking at the particulars of this investing theory to both understand why he advocated the elements of this theory and what Benjamin Graham would have thought of the approach that Greenblatt was advocating. The next part in this series looks at Return on Capital or ROC.

What is it?

Earnings Before Interest and Tax (EBIT)
Net Working Capital + Net Fixed Assets

EBIT is a raw calculation of the regular company income excluding the income from irregular or non-reoccurring activities.

In the denominator Greenblatt doesn't use the traditional element of Enterprise Value. (Should he have we could have jumped all over him for using another equation that leverages Market Capitalization otherwise known as shareholder sentiment) Instead he uses:

Net Working Capital = Total Assets - Total Liabilities
Net Fixed Assets = Purchase Price of All fixed assets (Land, buildings, equipment, machinery, vehicles, leasehold improvements) - Accumulated Depreciation

What Does it Tell Us?

By taking EBIT and putting it over Capital + Fixed Assets you have an earnings formula. You are saying what does it cost to run this money making machine? Let me explain.

Consider any company to be a money making factories- as essentially that is what we, as investors, hope it will be. If the company bought one machine that costs $100M (Net Fixed Asset), they own the machine outright and require no other assets (Net Working Capital) and the machine creates 10 $1M bills per year (EBIT) then you have:
$10M/ ($100M-$0) or return on capital of 10%. Or it put it another way for every dollar invested into the core of the company $.10 are generated in raw earnings.

The higher the number the better the return the company gets from buying the money making machine. A company therefore that has the same machine but is only capable of producing 1 $1M bill is therefore a less appealing investment.

So What Would Graham Think about this Rule?

Graham would have seen the value of understanding the return on capital. One can imagine though that the most recent return on capital would not suffice for Graham. He wanted a company with a past. There are always flash in the pan companies that have a phenomenal return on capital for one year. Just look at the company that makes croks if you need an example, for the year they were popular they had a fabulous ROC but the year before and the year after showed dismal results. One can imagine Graham would have thought that a year was simply not long enough. True, Graham believed in P/E ratio which can be accused of the same shortcomings, but he complimented that with an insistence that the company also possess
Some earnings for the common stock in each of the past ten years.

P348 The Intelligent Investor
This would mitigate some of the flash in the pan potential.

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


Anonymous said...

The denominator of the formula is "Net Working Capital + Net Fixed Assets", not "Net Worth Capital...". Big difference.
Otherwise, great post.