One way to minimize this problem is to look at the earnings before interest and tax (Ebit), a number before all the extra-ordinary items such as gain in revaluation of assets, gain in foreign exchange, gain from sales of land and other assets etc which are one time off and non-recurring.
As Ebit is the income for both the equity and debt holders, enterprise value is used instead of the market capitalization. This ratio of EV/Ebit replaces the too simplistic P/E ratio to determine if a company is worth buying.
EV/Ebit, like the PE ratio, is a measure of how cheap, or expensive a stock is selling. It doesn’t take into consideration if the performance of the company is good or not. Of course a better performing company should rightfully be selling at a higher P/E, or EV/Ebit ratio. To complement that, we also use return on capital (ROC) first to determine if the company is a good company, then if it is selling cheap. That is the essence of the Joel Greenblatt Magic Formula Investing.
K C Chong (6th November 2014)
Appendix
| Stock name | Closing price 6/6/14 | EBIT/EV | ROIC |
Price 6/11/14
|
Dividend
|
Total
|
Total return
| |
1
| MMODE |
0.69
|
16.9%
|
37.9%
|
0.605
|
0.005
|
0.61
|
-11.6%
|
2
| HOMERIZ |
0.78
|
23.3%
|
47.8%
|
0.830
|
0.01
|
0.84
|
7.7%
|
3
| WILLOW |
0.8
|
15.2%
|
51.1%
|
0.87
|
0
|
0.87
|
8.7%
|
4
| FIBON |
0.48
|
23.8%
|
37.1%
|
0.45
|
0
|
0.45
|
-6.2%
|
5
| SKPRES |
0.415
|
23.3%
|
19.9%
|
0.755
|
0.017
|
0.772
|
86.0%
|
6
| PTARAS |
4.11
|
14.2%
|
31.0%
|
4.54
|
0.06
|
4.6
|
11.9%
|
7
| SCC |
1.56
|
11.5%
|
27.7%
|
1.34
|
0.05
|
1.39
|
-10.9%
|
8
| MAGNI |
2.89
|
20.4%
|
24.1%
|
2.94
|
0.03
|
2.97
|
2.8%
|
9
| LATITUD |
2.94
|
23.3%
|
28.9%
|
3.82
|
0
|
3.82
|
29.9%
|
10
| CENBOND |
1.41
|
22.2%
|
17.4%
|
1.35
|
0.02
|
1.37
|
-2.8%
|
11
| TURBO |
1.38
|
12.2%
|
30.7%
|
1.12
|
0
|
1.12
|
-18.8%
|
12
| SAPIND |
1.73
|
14.9%
|
16.4%
|
1.44
|
0.08
|
1.52
|
-12.1%
|
13
| KFIMA |
2.17
|
21.3%
|
17.0%
|
2.04
|
0.08
|
2.12
|
-2.3%
|
14
| MFCB |
2.3
|
27.1%
|
15.8%
|
2.58
|
0.03
|
2.61
|
13.5%
|
15
| APM |
6.05
|
15.6%
|
20.6%
|
5.6
|
0.075
|
5.675
|
-6.2%
|
16
| CHEETAH |
0.555
|
26.3%
|
9.2%
|
0.555
|
0
|
0.555
|
0.0%
|
17
| PPG |
0.535
|
29.4%
|
9.5%
|
0.55
|
0
|
0.55
|
2.8%
|
18
| JOHOTIN |
1.66
|
19.6%
|
13.4%
|
1.47
|
0.02
|
1.49
|
-10.2%
|
Magic Formula - Joel Greenblatt
- Magic Formula to beat the market by Joel Greenblatt, a top-performing hedge fund manager since the 1980s
- A long-term investment strategy designed to buy a group of above-average companies (High return of capital) when they are available at below-average prices (low EV/Ebit)
- Earnings Yield = EBIT / Enterprise Value
- Enterprise value = Market capitalization + Total Debts + Minotiry Interest – Excess cash
- Return on Capital = EBIT / (Fixed Assets + Net Working Capital)
- Fixed assets generally is the property, plant and equpment
- Net working capital = Receivables + Inventories – Payable
- Formula
- Establish a minimum market capitalization (usually greater than $50 million).
- Exclude utility and financial stocks.
- Exclude foreign companies (American Depositary Receipts).
- Determine company's earnings yield = EBIT / enterprise value.
- Determine company's return on capital = EBIT / (net fixed assets +working capital).
- Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
- Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
- Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
- Continue over a long-term (3–5+ year) period.
- It outperformed S&P 17 out of the 22 years and achieved a compounded annual growth of 23.8% as compared to the 9.6% of S&P.
- Why it works?
- Most investors tend to avoid buying many of the biggest winners
- Why Cheap? the near future for a company might not look quite as bright as the recent past or there’s a great deal of uncertainty about the company for one reason or another
- It systematically avoided by both individuals and institutional investors
- Investors tend to sell their good stocks after they underperform for some time.
- It’s hard to stick to a seemingly good stock that’s not working for a little while.
- Many Investors sell their good stocks after the market and their portfolio declined
- It should work better in Bursa than US
- less institutional investor and hence less followers of this magic formula
- institutional investor have no mandate to buy stock meet the magic formula - which most of them is small & mid cap stocks
- retail investor is not savvy in fundamental investing - don't know how to determine a good company or a good price.
- retail investor normally relying on IB's report (who have their own interest) or listen to the rumours in the market
- retail investor influenced by greed and fear,
- Improvement on Magic Formula
- Steady income for pass few years
- Quality on earning - check the cash flow
- Opg Cash Flow close to or above net profit
- FCF positive most of the year- 10% of invested capital, 5% of revenue
- Healthy balance sheet - little & manageable debt (low risk)
- Price is well below the DCF intrinsic value (huge MOS)
- Some growth.....
- Mr. Chong Magic Formula's Pick
References:
- The Magic Formula Investing Strategy kcchongnz
- http://en.wikipedia.org/wiki/Magic_formula_investing
- ROIC-Greenblatt-and-Fool-Articles
- A Reflection of My Experience in Magic Formula Investing kcchongnz
Source: http://intelligentinvestor8.blogspot.com/