magic formula of Value investing

Definition of a Company:
A company is a system which converts cash into inventory into revenues and back into [more] cash again.
Some companies do this conversion very fast, some do it slowly.
Cash is king and how a company creates cash using the capital it has is what seperates diamond from coal.
Lets see where we can go from here...
Greenblatt's backtesting shows thatbuying stocks that rank highest in a combination of => earnings yield (the inverse of the price-to-earnings [P/E] ratio) and=> return on capital.have doubled the market's returns.Its important to pay close attention to return on invested capital for a long time.Since this is the most simple measure of the effectiveness of the whole company.
Buying low-priced stocks (low P/Es = high earnings yield) that also are the best at making profits on their invested capital is something that has a great deal of intuitive appeal.
More on ROICReturn on invested capital (ROIC) is a measure of financial performance.=>Looking at economic earnings -- free cash flow (or return on invested capital) minus a charge for the use of that capital -- produces a much better view of the economics and value of a company than just looking at earnings growth.=>After all, earnings growth comes at a price in many instances -- whether that's heavy investment in working capital, fixed assets, or the issuance of stock to acquire other businesses.=>It's not profit margins that determine a company's desirability, it's how much cash can be produced by each dollar of cash that is invested in a company by either its shareholders or lenders.=>Measuring the real cash-on-cash return is what ROIC seeks to accomplish.
Why not use ROE?ROI is sort of like ROE, but greatly improves upon it. Return on equity (net income divided by average shareholders' equity in use over the period being looked at) takes into account in the denominator only the net assets in use by the corporation. A major problem with this is that certain liabilities mandated by GAAP (Generally Accepted Accounting Principles) reduce the amount of resources at the company's disposal in the ROE equation. Depending on the circumstances, though, these liabilities should not be counted as a reduction in the capital working for the benefit of shareholders. They should be counted as an addition to capital in use by shareholders. That being the case, moving an amount out of liabilities and into owners' equity necessarily increases the denominator of the ROE equation and thus lowers the company's return on equity.Not all assets are funded by owners' equity, so looking at just owners' equity as a measure against which return is compared is going to miss the boat at times. Those companies that finance their assets with just a sliver of owners' equity and a boatload of liabilities can drive the value of owners' equity to zero pretty quickly with just one misstep. A 20% return on owners' equity in a company with very low leverage (defining leverage for these purposes as the ratio of assets to owners' equity) is a much different and preferable result to a company with very high leverage generating an ROE of 20%. We need an alternative definition of capital that measures the full amount of capital in use by a company's managers, whether that capital was raised through equity or through debt. In other words, we want to look at the company's performance independent of its financing decisions. ROIC is the way to do that.Looking at ROIC tells an investor how efficiently the company is being run and how much cash is being generated per dollar of investment, independent of how management chooses to finance the company. Whether the company is financed with equity (by selling stock) or debt (by drawing on a bank line of credit or selling debt directly to interested investors), ROIC doesn't care. The idea is to have some sense of what the company's operating performance is regardless of the particular way that the company has financed its invested capital. This allows you as a potential shareholder (and business owner) to discern between the actual operating performance of the business and the side effects of how that business was financed.You want to look at operating performance independent of financing because conventional accounting does not treat all financing costs equally. While interest, the cost of debt, is reflected on the income statement, the more intangible (but no less real) cost of the equity capital is not reflected at all. What? You mean equity costs money? You bet your sweet belled cap it does! When a shareholder like yourself gets equity (or stock, for those inclined toward the less pretentious version), do you expect that the stock will increase in value? How much do you expect it to increase in value? That percentage increase is the cost of equity capital -- if investors do not get the return they expect, they will sell the stock to a new investor, who comes in expecting to earn his target return on the lower share price. The consensus expectation of all investors who own the stock is the cost of equity capital. Just because it is not deducted out of earnings like debt doesn't make it any less real.
Cost of Equity? Isnt Equity Free?Though the cost of equity does not show up on a company's income statement, it is not free. Investors expect a rate of return on equity that is in line with the Nifty50 or Nifty500 and that also takes into account the specific risks of the company in question. Say for a company that has an average debt-to-equity ratio of 109% in the year 7 and may also be operating in a slower-growth industry with poor economics to begin with. In that case, we would demand a rate of return on equity of about 1.2 times the Nifty 500's historical return to compensate for the extra risk. That means that the equity being used by this business will cost it 13.2%. A lower return on equity will hurt the valuation of the company's equity and ultimately the multiple the market will pay for all the capital invested in the business as well as its earnings and cash flow.
How to add up up the capital at work, =>According to the theoretical work of Bennett Stewart III in The Quest for Value: The EVA Management Guide=>You can add up the capital in use by a firm by focusing primarily on the right-hand side of the balance sheet (where you find liabilities and owners' equity)=>or by looking primarily on the left-hand side of the balance sheet, which is where assets are found.=>Remember, assets minus liabilities equals owners' equity -- the bottom line on a balance sheet. Rearranging the equation, though, gets us to an expression of how all assets are funded on a balance sheet: assets = liabilities + owners' equity.So, we can calculate invested capital as being equal to all financial capital.
We can also look at it starting from the asset side.
Start with all assets and deduct non-interest bearing current liabilities.
The liabilities of accounts payable and accrued compensation expenses do not represent capital invested in the business by either equity or debt holders.
While they are debt under the most stringent forms of looking at the balance sheet, they don't represent invested capital. As long as a company pays its vendors within standard or agreed upon terms, accounts payable are not interest-bearing liabilities.
As for accrued compensation expenses, any company that doesn't pay by the day is going to operate with an average level of these liabilities all year long. The value of work that an employee renders is found in inventory, if the company is a traditional manufacturer. Since many people are paid on a bi-weekly schedule, the value that the employee renders in labor between paydays is accrued. It's pretty much an interest-free short-term loan of labor.Now we have to adjust the return before dividing it into invested capital to calculate ROIC. The net income figure that is used in the calculation of return on equity is not directly analogous to the "return" in ROIC. That's because ROE is concerned with the return on equity after all other financing sources have been taken care of.
Net Income? lets find it carefully.
Net income is net of interest expense as well as other expenses below the operating income line on the income statement.
We want to measure the income the company generates before considering what capital costs.
In this way, we are looking at the pure earnings power of a corporation before taking into account the decisions that were made to finance the business.the formula for ROIC is:After-tax operating earnings= --------------------------------------------------------------------------------------------[total assets minus non-interest-bearing current liabilities - Cash - GoodWill]Why is ROI so PowerFullROIC looks at earnings power in the context of how much capital is tied up in a business and what sort of return that capital is generating.
The whole idea of "earnings growing by such-and-such" takes on less importance as a stand-alone concept when you're looking at how much capital is being poured into a business.
It is real easy to grow your earnings by investing more money into the business.
However, it is not quite as easy to grow earnings by investing capital if you intend to maintain your current level of return on invested capital.Say there's a company that is able to grow operating earnings by 20% per year for six years, and you purchase it a P/E of 10. "Such a deal," you might think.
The conventional wisdom of investing teaches that P/E is a determinant of value and that a company growing at 20% per year should be worth far more than 10 times trailing earnings. However, while you're focusing on all that earnings growth, you might miss a deteriorating underlying trend of declining economic performance -- or in English, you may not notice that return on invested capital is dropping like a stone as the company invests in projects that earn smaller and smaller returns.An example which shows how EPS growth can get misleading while ROI shows the true pic. After-tax Invested Operating operating Capital ROIC Earnings earnings GrowthYear $500 1 $100 $600 18.2% 20%2 $120 $740 17.9% 20%3 $144 $999 16.6% 20%4 $172.8 $1,398.6 14.4% 20%5 $207.36 $2,097.9 11.9% 20%6 $248.83 $2,986 9.8% 20%7 $298.60 $3,881.8 8.7% 20%
(ROIC is calculated on average invested capital for each period)At the end of the period, the company's operating income is 199% higher than in year one. However, the company is currently investing in new projects that earn far less than what the original, core business did. In fact, given how low ROIC has dropped, the new projects are probably earning only 5% to 6% -- about what an investor can get in 100% secure, U.S. Government-issued 30-year bonds. What kind of fool would be happy that management is investing new money at a rate of return that an investor can get in a bond? Not very many, which is probably why the stock only trades at 10 times earnings.Companies Destorying Value?The above company hasn't built shareholder value because it has invested in projects with ROIC that is below the rate of return investors expect. That's because it has had to increase capital invested in the business at a faster rate than earnings and revenues have grown.
Receivables, inventory, building warehouses, and other capital assets such as presses and trucks have all been necessary investments to create the 20% earnings growth that shareholders have demanded. Over the intervening years, the company has had to take on lines of credit, issue commercial paper, and issue long-term debt and preferred stock to finance the expansion because internally generated funds were not sufficient to finance the growth. In spite of the fact that management has focused on earnings growth, the horrible returns on new capital being invested in the business are causing smart investors -- "lead steers," as Bennett Stewart calls them in his book -- to look elsewhere.What exactly are these "lead steers" looking for in a company? These investors want a company that is "beating" its "cost of capital" -- investing new money into projects that have ROIC that is higher than the expected returns shareholders demand.Is Growth always good for shareholders return?Rather than acting as a stand-alone conception of how well a company is operating, ROIC should be looked at in relation to the company's cost of capital. Companies such as Coca-Cola have operated on this system, called Economic Value Added, or EVA, for a number of years (as have leveraged buyout financiers).
The philosophy doesn't make these companies successful -- it's the implementation of it that makes a difference.
Not all successful companies operate based on EVA, either. Some managements think in this way to begin with. However, the readers should know that some of the biggest generators of shareholder value over the last two decades have embraced this philosophy. The company in our example would have stopped growing at a certain point to preserve shareholder value, forgoing growth for growth's sake. Taking too much debt which does not generates return near or more than cost of equity would slowly destory a companys shareholder equity. At a certain point, more of the value of the enterprise goes to its creditors than to its shareholders.When ROIC starts to drop, investors should pay attention. It can signal anything from a momentary blip in the company's progress to a decay in industry or company fundamentals. Successful companies in more mature industries (the characteristics defining success for companies in hypergrowth industries are much different) generate ROIC above and beyond their cost of capital -- in fact, this is one reason why the Nifty50 is priced the way it is and why it has outperformed the small and mid-cap universes. Companies in the Nifty50 are simply the creme de la creme of business and show a better spread between their return on invested capital and the cost of capital they use.In addition, the very good companies are able maintain excellent returns on invested capital even as they increase invested capital year after year, while others rationalize their operations and sell off those units that can't generate the ROIC that they see elsewhere in their company. By dumping such operations, a company's earnings can shrink, but the valuation on the remaining earnings and capital invested in the business can increase so that the company is now worth more.
How to account for Cash in ROIC calculations
Whether it's funded by liabilities or owners' equity, the cash represents capital that has been invested in the business. However, there is a difference between invested and deployed, which is where some investors and analysts differ in their view of ROIC.
the formula for ROIC is:After-tax operating earnings= --------------------------------------------------------------------------------------------[total assets minus non-interest-bearing current liabilities - Cash - GoodWill]
Some feel more comfortable with this definition because cash represents capital that hasn't been deployed in other assets or represents potential to reduce liabilities or owners' equity. I stand by this definition depending on the application. A distinction should be made between financial capital and invested capital. This is needed since mant times a large amount of cash may remain on the sidelines waiting to be invested !
In the case of a fast-growing company that has issued securities but has not yet deployed the cash from those issuances, we don't want to get too racy with what we consider as excess capital. We also don't want to unduly penalize the company's valuation just because we are taking a snapshot of the financials at a time when it has not yet had the chance to invest all the capital that it has at its disposal. A compromise is in order.
Depending on the capital intensity and the speed at which a company can turn inventory into cash (its cash conversion cycle), the invested capital base of the company should reflect only the cash balance that a company needs to have on hand to cover day-to-day cash outlay needs. For instance, most restaurants that aren't going under need to retain very little cash on hand because they operate in a cash business. Their inventory is turned into cash very quickly, while the payables for the inventory operate on a cycle not all that different from any other business with a good credit rating.
the new formula for ROIC is:After-tax operating earnings= -------------------------------------------------------------------------------------------------------[total assets - non interest bearing current liabilities - Excess Cash - GoodWill]
5% of sales in cash is probably a prudent level of cash to hold and anything beyond that can be deducted from the invested capital base.
In sumamryIts cash-on-cash returns are what we're looking for in calculating ROIC.The cash-on-cash return is literally the amount of cash you get back compared with the amount of cash you had to invest in the business.After removing all of the distortions created by accounting, looking at return on invested capital allows you to accurately measure how much cash you get out of a business for every dollar you put into it. The general rule is that the more cash you can get per dollar of investment, the better the business is. Now, whether the cash you are investing into the business is called an "expense" and simply deducted from revenues (like Cost of Goods Sold or Sales, General & Administrative expenses on the Statement of Income) or whether those expenses are "capitalized" and turned into an asset that is placed on the Consolidated Balance Sheet, ROIC can let you see how well the company is actually doing, independent of the accounting method chosen by a company's management.By looking at a company's financials from the standpoint of ROIC, an investor considers what's going on with both the income statement and the balance sheet. The various ratios that an investor considers (leverage, cash conversion cycle elements, margins, asset turnover) are brought together under the unified ROIC model. ROIC also allows an investor to look through the various accounting choices that a company can make to portray earnings. As most accounting regimes are rich in balance sheet accruals, ROIC is able to identify the real economic return a company generates. Those expenses that don't go into net income stay home on the balance sheet as part of the company's invested capital. So, what doesn't get considered in the numerator in ROIC has to be considered in the denominator._________________________________for detailed reading visithttp://magicformulainvesting.comhttp://www.fool.com/School/roic/roic.htmalso visit http://www.fool.com/School/HowtoValueStocks.htm to find more gems and ideas

from rajeev mundra