The Investing for Beginners Podcast - Your Path to Financial Freedom
The Investing for Beginners Podcast - Your Path to Financial Freedom
Andrew Sather and Dave Ahern
IFB26: Combining Earnings Yield and the Return on Capital Formula
34 minutes Posted Aug 11, 2017 at 4:00 am.
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Welcome to episode 26 of the Investing for Beginners podcast. In today’s show, we will discuss the return on capital formula by Joel Greenblatt. The Magic Formula is a great formula that helps identify companies with a low P/E ratio and a great return on capital. This show will continue some discussion of numbers and formulas, so for those of you that are not fans of math, we will break it down into the easiest forms that we can so it doesn’t overwhelm you.
What we will learn today:

* Breakdown of the Magic Formula
* Defining earnings yield
* Defining return on capital
* How the Magic Formula works
* Finding a strategy that works for you

Andrew: This is a formula that is very value investing based and Joel Greenblatt, he is a fund manager who has had a ton of success with this formula. He saw a lot of success, made a bunch of people a lot of money. Then went out and wrote a book laying this formula out, and how he picks stocks.
Very reminiscent of my Value Trap Indicator formula, except he obviously has a much longer track record than I do. In the sense that there are these specific rules and basic equation that is based on pure financials.
He took that magic formula as he calls and he put it in a book called “The Little Book That Beats the Market.” Ended up being a best seller and went on to do well. I know he had a period where he was making 20 or 30 percent return per year for decades. Crazy returns recently haven’t been as strong as it was in the past.
Just like with any value investor, guys like Buffett who might underperform during a really strong bull market there are always periods they will outperform or underperform. It depends as we talked before, backtesting depends on where you draw the line and what time range you are evaluating, but a guy like Joel Greenblatt and this Magic Formula has proven to do extremely well for a very long period.
It is obviously something that’s worth discussing. It is kind of technical, and there are some numbers behind it. As I do with all numbers or metrics, valuations, obviously this is a podcast that is structured for beginners so I want to take these complicated topics and try to make them as simple as we can.
That is going to be the goal for this episode, and hopefully, even as you’re listening, you’ll be able to get some insight into that and start to see some things click. So that you can say, this is just another tool to have in my toolbox. And another piece of information to know, or strengthen your beliefs in some other tactics you might use, that are similar yet maybe not completely the same.
A lot of those type of principles do apply here as well. Do as when you’re a value investor those type of things can apply for yourself as well.
He just breaks it down into two components, and the magic formula is based on the earnings yield and the return on capital. If you go back and listen to one of our most popular episodes, it’s called the Useful Guide for Stock Market Valuations. We talk about some of the most common valuations, and one them that we discuss is the P/E ratio.
This ratio is discussed all the time, in the blogs, media, and even on TV. Almost any book you open up will mention P/E in some way or other.
When you look at P/E and earnings yield, understand that it is the same thing. Earnings yield just the PE flipped, so where the P is the price to earnings,