Greenblatt Earnings Yield was founded by Joel Greenblatt, a hedge fund manager also known as a legendary stock-picker on wall street. He published the popular book, called The Little Book that Beats the Market in 2005.
Joel Greenblatt combined the strategies used by ace investors like Warren Buffett and Benjamin Graham to devise a simple value investing method.
The Greenblatt Earnings Yield is a methodology designed by him that aids stock picking. It is also known as the Magic Formula.
The Magic Formula evaluates stocks and ranks them based on two financial ratios – earnings yield and return on invested capital (ROC). But is it actually a magical solution to all your investment woes? Let’s find out.
Formula of Greenblatt Earnings Yield
The Greenblatt Earnings Yield is based on two metrics – Return on Capital and Earnings Yield.
- RoC is the company’s earnings before interest and taxes (EBIT) expressed as a proportion of its net fixed assets and net working capital
EBIT / (net working capital + net fixed assets).
- EY is defined as EBIT upon enterprise value (EV.
EBIT / EV.
RoC is a common ratio used to compare the financial strength of companies and earnings yield can gauge whether a company is under-or over-valued when compared to its peers.
EV is a better judge of a company’s liquidity position since it takes into account debt and EBIT looks at actual operating earnings before interest expense and taxes.
Also, tangible capital employed is considered as it is a better measure of the capital required to run a business. The higher the ROC and yield, the better!
Once you get a list of companies by running these two formulas, the companies are separately ranked (where 1 is the company with the highest ROIC/ EY) in the descending order of ROC and EY. Both the rankings are then combined and the lower the combined numerical ranking, the better, according to this Magic Formula.
Remember to establish a minimum market cap limit to get a list of all stocks that meet the criteria and exclude utility and financial stocks as well as foreign companies.
The magic formula investing approach recommends rebalancing your portfolio once a year. Investors can sell loss-making shares before the year and use the capital loss to offset capital gains.
Quoting Warren Buffett, Joel said, “Buying a business at a bargain price is great. However, buying a good business at a bargain price is even better.” The Magic Formula aims at buying mispriced stocks with high earnings yield and high return on capital.
Pros of Greenblatt Earnings Yield
- A good combination of Ben Graham’s preference for cheap stocks and Warren Buffett’s preference for high-quality companies.
- Helps to unveil high-quality stocks at cheap prices.
- Provides a fair comparison between companies having different levels of debt and different tax rates when comparing earnings yields.
- It is useful to evaluate large-cap companies.
Cons of Greenblatt Earnings Yield
- It does not consider the growth of the company.
- It only relies on quantitative measures.
- It only looks at one year’s performance.
- Not best for cyclical companies, where earnings yield is highest at the peak of the business cycle.
- It does not apply to small-cap stocks, financial companies, and utilities.
Greenblatt Earnings Yield focuses on finding out fantastic businesses at attractive prices.
However, the magic formula is just one step. Investors need to do their own research on stocks that get filtered through the magic formula test.
One should also consider the sustainability of the business, growth prospects, and management quality before making a decision. Greenblatt also advises investors to remain invested for the long term to see the actual magic unfolding.
“If everyone used [the magic formula], it would probably stop working. So many people would be buying the shares of the bargain-priced stocks selected by the magic formula that the prices of those shares would be pushed higher almost immediately. In other words, if everyone used the formula, the bargains would disappear and the magic formula would be ruined!”— Joel Greenblatt