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)
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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
- 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
- It’s hard to stick to a seemingly good stock that’s not working for a little while.
- 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,
- 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.....
- http://klse.i3investor.com/servlets/pfs/21089.jsp (stock picks write up athttp://klse.i3investor.com/blogs/stock_pick_challenge_2013_2h/blidx.jsp)
- The Magic Formula Investing Strategy kcchongnz
- A Reflection of My Experience in Magic Formula Investing kcchongnz