The Reasoning Behind Return On Capital in the Magic Formula

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What You Will Learn

• Why didn’t Greenblatt just use ROE?
• A deeper explanation of how Return on Capital is calculated
• Example of ROC between KO, PEP and DPS

“Businesses that earn a high return on capital are better than businesses that earn a low return on capital.” —Joel Greenblatt

The Reasoning Behind Return On Capital in the Magic Formula

The magic formula was introduced in the Little Book That Still Beats the Market written by Joel Greenblatt, and ranks companies based on two factors

1. return on capital
2. earnings yield

In this post we take at the first factor: return on capital.

This is what Greenblatt wrote in the little book:

The Magic Formula Version of Return on Capital

The formula used by Greenblatt is:

Greenblatt chose this version ratio rather than the common version of ROE or ROA for several reasons.

Why EBIT? The Reason for the Numerator

EBIT (or earnings before interest and taxes) is used in place of reported earnings because companies operate with different levels of debt and differing tax rates. This allows you to view and compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels.

For each company, it is then possible to compare actual earnings from operations (EBIT) to the cost of the assets used to produce those earnings (tangible capital employed).

For purposes of the study and in the interest of simplicity, it is assumed that depreciation and amortization expense (noncash charges against earnings) were roughly equal to maintenance capital spending requirements (cash expenses not charged against earnings).

Assumed that EBITDA − Maintenance Cap/Expenditures = EBIT.

The Reason Behind the Denominator

Here’s a look at closer look at how and why the denominator was chosen.

Net Working Capital + Net Fixed Assets (or tangible capital employed) is used in place of total assets (used in an ROA calculation) or equity (used in an ROE calculation).

The idea here is to figure out how much capital is actually needed to conduct the company’s business.

Net working capital is used because a company has to fund its receivables and inventory but does not have to lay out money for its payables, as these are effectively an  interest-free loan (short-term interest-bearing debt is excluded from current liabilities for this calculation).

As a side note, in this calculation, excess cash not needed to run the business was excluded. 

In addition to working capital requirements, a company must also fund the purchase of fixed assets necessary to conduct its business, such as real estate, plant, and equipment.

The depreciated net cost of these fixed assets is then added to the net working capital requirements already calculated to arrive at an estimate for tangible capital employed.

NOTE: Intangible assets, specifically goodwill, were excluded from the tangible capital employed calculations. Goodwill usually arises as a result of an acquisition of another company.

The cost of an acquisition in excess of the tangible assets acquired is usually assigned to a goodwill account. In order to conduct its future business, the acquiring company usually only has to replace tangible assets, such as plant and equipment.

Goodwill is a historical cost that does not have to be constantly replaced. Therefore, in most cases, return on tangible capital alone (excluding goodwill) will be a more accurate reflection of a business’s return on capital going forward.

The ROE and ROA calculations used by many investment analysts are therefore often distorted by ignoring the difference between reported equity and assets and tangible equity and assets in addition to distortions due to differing tax rates and debt levels.