Category Archives: Valuation Techniques

Lesson on Franchises in Cyclical Markets




Money Managers Are Price Chasers

Markets can do ANYTHING in the short-term, so the following is not a prediction that miners will rise in price. However, what comes first–the price rising or the buying? :) Miners chop around in a trading range as money managers flee the sector and now sit with record low allocations to this sector. * How good are money managers (on the whole) picking the right sector to invest in?  I leave it to you to find that out.

Wedgewood Partners: Franchises in Cyclical Market and a Lesson on Diversification

wedgewood partners fourth quarter 2014 client letter Look at pages 12-20 where David Rolfe, the manager, discusses NOV, SLB and CLB–high-quality companies in the cyclical oil sector.

  1. clb_vl
  2. slb_vl
  3. nov_vl

He points out diversification may mean the sources of profitability can be different among companies within a particular sector.  (Refer to Competition Demystified by Bruce Greenwald for a course on this distinction). Note the high revenue conversion to free cash flow (page-14) for those companies compared to other companies in the oil services sector.

Now move on to wedgewood partners first quarter 2015 client letter crude realities.  Note on page 13 how he looks at the oil services market–the structural attribute to focus on is drilling intensity.  Interesting…. Look at pages 18 and 19 for a further discussion on NOV and CLB.

To learn, you might download those company’s recent annual reports and try to figure out their revenue to free cash flow conversion.  Look at what the companies use for maintenance capex.  Note how Core Labs is a free cash flow gusher (Charlie Munger would smile on this).  Core Labs is a different business than SLB and NOV, but is grouped in the same industry/index.  When sellers of ETF sell, they don’t distinguish among companies and therein lies opportunity for us. Yeah!

I do the opposite of this:

**Merrill Lynch Fund Managers Survey May 4, 2015

Today’s chart of the day focuses on sentiment in the basic materials sector. Regular readers of the blog already know that I have been closely following Merrill Lynch’s Fund Manager Survey for years now. This months survey was conducted in a period between 2nd to 9th April 2015 with a total of 177 panellists, with $494 billion of assets under management. The survey should be used as a very good contrarian indicator.

According to the recent survey, global fund manager allocation towards global materials declined sharply in the month of April to net 27% underweight from net 16% underweight the previous month. As we can clearly see from todays chart of the day, sentiment is very depressed right now. Merrill Lynch states that the current allocation is 1.8 standard deviation below its long term average.

Furthermore, the overall commodity and natural resources theme is very much disliked by global money managers. Commodity allocation is unchanged for the third straight month and remains at net 20% underweight. That is 1.2 standard deviations below its long term average and even more interestingly, fund managers remain underweight commodities for the 28th month in the row.


Prof. Greenwald on Value Investing

OVERVIEW Value_Investing_Slides

Greenwald_2005_Inv_Process_Pres_Gabelli in London

Greenwald Overview of VI

A Value Investing Class in Three Minutes

Buying High

Next Week

I have been too busy to do another lesson but be ready next week! For those attending the Berkshire Hathaway Meeting in Omaha enjoy the experience. Flash your Deep-Value Group card for up to 95% discounts.


Don’t Spare the Rod: Critique of Investment Research Reports

Time WarnerA beginning analyst sent me a research report to discuss: Ensco PLC Write-Up

Now before I start, realize that when I was beginning, my idea of a research report was to mimic Cramer.  Buy because the “chart” looks good and I gotta feelin’.  One time my hedge fund boss said his time was worth $1,000 an hour so the six minutes he took to read my incoherent report meant that I OWED HIM, $100.  Well, we all have to start somewhere.  The point of this exercise is to learn.

Buffett’s punch   idea may apply. If you only had twenty investment ideas over a lifetime–one every two to three years–would this be it? Would you put all of your money and family’s money into the idea and why?

Or, you pretend that you have a 45-second ride in the elevator to the top of the Time Warner building with Carl Icahn while selling your idea.

Bill Miller once said that money managers had the attention span of knats. You had to summarize your thesis and then give three or four supporting reasons within thirty seconds.

My critique of Ensco PLC

Instead of four paragraphs to tell me what Ensco does, perhaps you can be more succinct while putting forth what is compelling about your investment thesis.

ESV (Ensco, PLC) is an owner/operator of offshore contract drilling rigs/services that is trading at X% under tangible book value.  This is a cyclical, asset-intensive business subject to swings in natural gas and oil prices. Over a fully cycle, the company earns normal returns on capital of XX?

The price: Enterprise Value

Returns: over several prior cycles?

Capital structure and terms of debt?

Bottom line: this is a non-franchise or asset-based investment that is currently and cyclically out of favor.  OK.   But if this is an asset based business what are the assets worth?  You would need to dig into tangible book–what is there?   What is the current and expected replacement value of their assets? Liquidation value?  Is their fleet of rigs unique? Who are their competitors?  Any hidden assets or potential assets like, say, NOLs or assets outside their core business for example?

What is their cash flow and owner earnings?   I would like to see enterprise value over EBITDA-MCX over the past decade to get an idea of how the market priced ESV over a cycle.

Who is management? What skin do they have in the game? Are they good operators and capital allocators? Insider buying?  Who owns this company?  I don’t have much to go on in the above report so I jump to my handy VL: ESV_VL.  Whoa!  I see debt has jumped about 35% from 2013. How does their capital structure compare to competitors?   It seems like there isn’t much free cash flow. Capex eats up most of the company’s cash flow.

Where is the margin of safety? Book value has been growing but during an up-cycle in drilling. What happens in a prolonged down-cycle?  What are the risks?   You mention a DCF? Where did that come from? Your assumptions?

I will let others in the Deep-Value group chime in, but for a first-ever research report I give a D- which isn’t bad. At least the writer has good instincts to look at an out-of-favor company, but the core analysis of the assets needs to be provided. Also the competitive landscape.  Obviously, it is a business without a competitive advantage due to the low and cyclical nature of the returns, so how does this business compare operationally, financially and value-wise to their main competitors? Who are their customers and how are they faring?

The only way to improve is to write, practice and look at other reports. Go to and sign up. Then look at the highest rated ideas and study those along side the 10-K of the company mentioned.

Study Other Examples of Research

Or The_Security_I_Like_Best_Buffett_1951  Warren Buffett on Geico. (you may have to paste into your browser) and as reference, Rockwell Automation Inc and ROK_VL from a Deep-Value member, Thomas Harris. We can critique this next if you wish.

Carl Icahn paid $500,000 for an investment bank to furnish a report on breaking up Time-Warner: lazard_twx (worth a look!) and Icahn was right about Time Warner

Analyzing Debt

Sell ABX

ABX Sombull along with Barrick Annual Report 2014 and Barrick 1 Q 2015

Stay with it………writing is hard and finding great ideas even harder.

Time-Out: Special Situation of a Capital Change (BB) GWW

Thin ICe

 I spilled spot remover on my dog. Now he’s gone. — Steven Wright

W. W. Grainger (GWW)

Someone asked what data tools do I use.  My brain and a Value-Line.

Try to look at the Value-Lines WITHOUT looking at the price of the stock. What would you pay for this entire business–not knowing what it did and the current price of the company?  Start with the numbers (excluding the stock price, at first) so to keep your prejudices at bay.   Maybe have a friend print out the Vale-Line and cut off the top of the page.

GWW_VL Jul 2014 and GWW_VL   Something should strike you about this business. What?  Asset or franchise?

A competitor: Fast VL

Grainger_ Capital Allocation-FINAL Whoa? An announcement of a capital structure change–so a type of special situation.  What does this mean?

Grainger_ 2015FactBook Time to dig deeper Grainger_2014_ARGrainger 14BALSTGrainger 14EARN

Ok, about what is this company worth and what type of return could I expect at today’s _____ price?

Not a recommendation! Do your own thinking because then you learn from your mistakes AND successes.

If you don’t know or are not sure; it is just too tough, difficult, or confusing, then you can always do this:


And when I see the sign that points one way
The lot we used to pass by every day

Just walk away, Renee
You won’t see me follow you back home
The empty sidewalks on my block are not the same
You’re not to blame

From deep inside the tears that I’m forced to cry
From deep inside the pain that I chose to hide

Just walk away, Renee
You won’t see me follow you back home
Now, as the rain beats down upon my weary eyes
For me, it cries

Just walk away, Renee
You won’t see me follow you back home
Now, as the rain beats down upon my weary eyes
For me, it cries

Your name and mine inside a heart upon a wall
Still finds a way to haunt me though they’re so small

Just walk away, Renee
You won’t see me follow you back home
The empty sidewalks on my block are not the same
You’re not to blame

Investment Checklists-Adapt Them for Yourself. GOODHAVEN


Someone sent me a postcard picture of the earth.
On the back it said, “Wish you were here.” — Steven Wright

Investment Checklists 

We left-off here Last Lesson on Gross Profitability and Magic Formula and in that post, the next focus would be on investment checklists.  We have been reading Chapter 2: A Blueprint to a Better Quantitative Value Strategy in Quantitative Value (I will email the Book to new students if they are in the Deep-Value Group at GOOGLE. Go here:!overview then type: DEEP-VALUE and ask to join.).

On pages 56 to 59 of this chapter the author discusses the case for a checklist. Atul Gawande in his book The Checklist Manifesto: How to Get Things Right argues for a broader implementation of checklists. The author believes that in many fields, the problem is not a lack of knowledge but in making sure we apply our knowledge consistently and correctly. 

The Quantitative Value Checklist

  1. Avoid Stocks that can cause a permanent loss of capital or avoid frauds and financial distress/bankruptcy.
  2. Find stocks with the cheapest quality.
  3. Find stocks with the cheapest prices.
  4. Find stocks with corroborative signals like insider buying, buyback announcements, etc.

Below are several books on checklists.

As students may know, I throw A LOT of information at you to force a choice on your part.   You have to focus on what material can be adapted to your needs. In the three books above, you will find many interesting ideas that may be helpful in learning how to build your own list.

The more experienced you are, then the shorter the checklist.  The point of a checklist is to be disciplined and not overlook the obvious while freeing up your mind for the big picture.   Yes, you check off if there is insider buying, but if insiders are absent, but the company has a strong franchise and the price is attractive, then those factors may be overwhelmingly positive.  You may ask, “Do I understand this business?” Then it may take weeks of industry reading to say yes or no.

Checklists are helpful, but only if you adapt them to your method.

Next, we will be reading Chapter 3, Eliminating Frauds in Quantitative Value. We are trying to improve our ability to build a margin of safety.


The Problem with Investor Time-frames

Note the dark line in the chart above representing the returns of the Goodhaven Fund. Two analysts/PMs split off from Fairholme and started in mid-2011. They had a big inflow in early 2014 and then some of their investors panicked as they vastly “underperformed the market.”  I don’t know if these managers are good or bad but making a decision on twelve to twenty-four months of data is absurd unless the managers completely changed their stripes (method of investing).  Therein lies opportunity for those with longer holding periods like five years or more.


Shareholder_Message_1114 (Some investors run for the door)





Commodities Carnage; Reversion to the Mean and the Growth Illusion; Net/Nets


CRBSearch Strategy: Go where the outlook is bleakest (John Templeton). Keep his wisdom by your side: Sixteen Rules for Investment Success_Templeton

Commodities (CRB Index) fall back to a 40-year support zone ($185/$205)


As global commodities prices plummet, it’s incredibly convenient to pronounce the commodities super-cycle dead, isn’t it?  Yet banks from Goldman Sachs to Citigroup to Deutsche Bank are on record as saying it’s over.

The point is not to follow the “experts” but search where there is carnage. I am looking at Templeton’s Russian and Eastern Europe Fund TRF Semi Annual Report because:

  • Hated Countries (Russia, Ukraine)
  • Currencies Down,
  • Commodity Exporters and
  • trading at a 10% discount so the 1.4% management fee is covered for six years.
  • Poor performance for the past few years

Things can and will probably get worse. So please don’t follow the blind (me) off the cliff. This is meant as an example of a SEARCH STRATEGY.

More on Reversion to the Mean and the Growth Illusion

We are beating this subject to death but you can’t understand how investing in bargains works without grasping these concepts.

Contrarian Strategy Extrapolation and Risk  Abstract: Value strategies yield higher returns because these strategies exploit the sub-optimal behavior of the typical investor and not because these strategies are fundamentally riskier.  Yes, this is an academic paper, but worth reading to understand WHY and HOW value (buying stocks with low expectations/and low price to business metrics like earnings, cash flow, EBITDA, etc.) provide better returns.

Growth Illusion

The Two Percent Dilution It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900–2002 is negative. Economic growth occurs from high personal savings rates and increased labor force participation, and from technological change. If increases in capital and labor inputs go into new corporations, these do not boost the present value of dividends on existing corporations. Technological change does not increase profits unless firms have lasting monopolies, a condition that rarely occurs. Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.

value-vs-glamour-a-global-phenomenon (Brandes Institute)

Thick as a Bric by Efficient Frontier

Does the Stock Market Over React

Discussion of Does the Stock Market Over React

Criticism of the Over Reaction Theory

The above is meant to supplement your reading in Deep Value Chapter 5, A Clockwork Market


Ben Graham’s Net-Net Strategy Revisited

Ben Graham Net Current Asset Values A Performance Update

R-T-M, Gross Profitability, Magic Formula

Our last lesson was in Mean Reversion (Chapter 5 in Deep Value) discussed  View this video on a very MEAN Reversion.

We must understand full cycles and reversion to the mean.  Let’s move on to reading Chapter 2: A Blueprint to a better Quantitative Value Strategy in Quantitative Value.

Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas. -Warren Buffett, Shareholder Letter, 2000.


Greenblatt defined Buffett’s definition of a good business as a high Return on Capital (ROC) – EBIT/Capital

Capital is defined as fixed asses + working capital (current assets minus current liabilities) minus excess cash.

ROC measures how efficiently management has used the capital employed in the business. The measure excludes excess cash and interest-bearing assets from this calculation to focus only on those assets actually used in the business to generate the return.


High earning yield = EBIT/TEV

TEV + Market Cap. + Total debt – minus excess cash + Preferred Stock + minority interests, and excess cash means cash + current assets – current liabilities.EBIT/TEV enables and apples-to-apples comparison of stock with different capital structures.

Improving on the Magic Formula?

ROC defined as Gross profitability to total assets.

GPA = (Revenue – Cost of Goods Sold)/Total Assets

GPA is the “cleanest” measure of true economic profitability.

See this study Gross Profitability a Better Metric and see pages 46-49 in Quant. Value. (the book was sent to deep-value group on Google)

The authors found GPA outperformed as a quality measure the magic formula.  Note on page 48, Table 2.3: Performance Stats for Common Quality Measures (1964 – 2011) that most simple quality measures do NOT provide any differentiation from the market!

FINDING PRICE, Academically–Book value/Market Price

The authors found that analyzing stocks along price and quality contours using the Magic Formula and its generic academic brother Quality and Price can produce market beating results 

The authors: “Our study demonstrates the utility of a quantitative approach to investing. Relentlessly pursuing a small edge over a long period of time, through booms and busts, good economies and bad, can lead to outstanding investment results.”

Ok, let’s come back to quality and avoiding value/death traps in the later chapters (3 and 4) in Quantitative Value.  We are just covering material in Chapter 2. 


Investors and the Magic Formula

Adding Your Two Cents May Cost a Lot Over the Long Term by Joel Greenblatt
01-18-2012  (Full article: Adding Your Two Cents

Gotham Asset Management managing partner and Columbia professor Joel Greenblatt explains why investors who ‘self-managed’ his Magic Formula using pre-approved stocks underperformed the professionally managed systematic accounts.

So, what happened? Well, as it turns out, the self-managed accounts, where clients could choose their own stocks from the pre-approved list and then follow (or not) our guidelines for trading the stocks at fixed intervals didn’t do too badly. A compilation of all self-managed accounts for the two-year period showed a cumulative return of 59.4% after all expenses. Pretty darn good, right? Unfortunately, the S&P 500 during the same period was actually up 62.7%.

“Hmmm….that’s interesting”, you say (or I’ll say it for you, it works either way), “so how did the ‘professionally managed’ accounts do during the same period?” Well, a compilation of all the “professionally managed” accounts earned 84.1% after all expenses over the same two years, beating the “self managed” by almost 25% (and the S&P by well over 20%). For just a two-year period, that’s a huge difference! It’s especially huge since both “self-managed” and “professionally managed” chose investments from the same list of stocks and supposedly followed the same basic game plan.

Let’s put it another way: on average the people who “self-managed” their accounts took a winning system and used their judgment to unintentionally eliminate all the outperformance and then some! How’d that happen?

1. Self-managed investors avoided buying many of the biggest winners.

How? Well, the market prices certain businesses cheaply for reasons that are usually very well-known (The market is a discounting mechanism). Whether you read the newspaper or follow the news in some other way, you’ll usually know what’s “wrong” with most stocks that appear at the top of the magic formula list. That’s part of the reason they’re available cheap in the first place! Most likely, 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. Buying stocks that appear cheap relative to trailing measures of cash flow or other measures (even if they’re still “good” businesses that earn high returns on capital), usually means you’re buying companies that are out of favor.

These types of companies are systematically avoided by both individuals and institutional investors. Most people and especially professional managers want to make money now. A company that may face short-term issues isn’t where most investors look for near term profits. Many self-managed investors just eliminate companies from the list that they just know from reading the newspaper face a near term problem or some uncertainty. But many of these companies turn out to be the biggest future winners.

2. Many self-managed investors changed their game plan after the strategy under-performed for a period of time.

Many self-managed investors got discouraged after the magic formula strategy under-performed the market for a period of time and simply sold stocks without replacing them, held more cash, and/or stopped updating the strategy on a periodic basis. It’s hard to stick with a strategy that’s not working for a little while. The best performing mutual fund for the decade of the 2000’s actually earned over 18% per year over a decade where the popular market averages were essentially flat. However, because of the capital movements of investors who bailed out during periods after the fund had underperformed for a while, the average investor (weighted by dollars invested) actually turned that 18% annual gain into an 11% LOSS per year during the same 10 year period.[2]

3. Many self-managed investors changed their game plan after the market and their self-managed portfolio declined (regardless of whether the self-managed strategy was outperforming or underperforming a declining market).

This is a similar story to #2 above. Investors don’t like to lose money. Beating the market by losing less than the market isn’t that comforting. Many self-managed investors sold stocks without replacing them, held more cash, and/or stopped updating the strategy on a periodic basis after the markets and their portfolio declined for a period of time. It didn’t matter whether the strategy was outperforming or underperforming over this same period. Investors in that best performing mutual fund of the decade that I mentioned above likely withdrew money after the fund declined regardless of whether it was outperforming a declining market during that same period.

4. Many self-managed investors bought more AFTER good periods of performance.

You get the idea. Most investors sell right AFTER bad performance and buy right AFTER good performance. This is a great way to lower long-term investment returns.

Luck-versus-skill-in-mutual-fund-performance by Fama

….We will finish the chapter with a study of checklists in the next post.

Interesting reading: The Crescent Fund (note reversion to the mean)  Oil Crash Pzena and

Go-where-it-is-darkest-when-company.html (Vale-Brazilian Iron Ore Producer).   Prof. Damordaran values Vale and Lukoil on Nov. 20, 2015.  I am looking at Vale because they have some of the lowest cost assets of Iron Ore in the world.  They have good odds of surviving the downturn but where the trough is–who knows. 

Valuing Cyclical Companies:

Valuing Cyclical Commodity Companies

CS on a Cyclical Business or Thinking About Cypress Stock

Letter to Cypress Shareholders about Price vs Value





I think the author at least knew of the risks, but underestimated the extent of the cycle due to massive distortions caused by the world’s central banks.  It did get iron prices fell another 10% and still falling. 

Month Price Iron Ore Change
Aug 2014 92.63
Sep 2014 82.27 -11.18 %
Oct 2014 80.09 -2.65 %
Nov 2014 73.13 -8.69 %
Dec 2014 68.80 -5.92 %
Jan 2015 67.39 -2.05 %
Feb 2015 62.69 -6.97


Damodaran: I have not updated my valuation of Vale (as of Feb. 20th), but I have neither sold nor added to my position. It is unlikely that I will add to my position for a simple reason. I don’t like doubling down on bets, even if I feel strongly, because I feel like I am tempting fate. 

Prof. Damodaran is responding to a poster who is asking about Vale’s plummeting stock price.  If you are a long-term bull you want declining prices to bankrupt weak companies in the industry so as to rationalize supply.


Dollar Panic; Valuation Ratios; Buyback Mania, CEFs


If you think nobody cares about you, try missing a couple of payments.- Wright.

Long-term view of the Dollar (DXY)

Oil service, oil producers, mining companies etc. are being hammered by a dollar “shortage.”  Opportunity may be knocking. Remember what Klarman said about forced selling.

An overview of the situation: Dollar Shortage. With money supply rising in the US there is no dollar “shortage”, but there is a fear of inter-bank lending.

Dollar Leverage BIS Report

Dollar Crisis 2009

JPM-dollar-shortage funding

A Guide to the Swap Market

Now the “experts” say confidently cnbc Dollar Euro Parity. Perhaps a bit late in a trend!   If you are to follow a trend then The Whipsaw Song

A Reader’s Question on Valuation Ratios.  This sheet may be good as a guide to go through an annual report, but none of those ratios means anything without context.   Is growth good? It depends. Only profitable growth within a franchise.  How about asset turnover?   For some companies like Costco asset turnover is critical but not for Boeing (gross margin).   Why not take those ratios and work through the financials of these trucking companies.  Which company is doing the best? Why? Follow the money!   Those ratios may help you structure the information you pull out from the financials. But first focus on how does the company provide a service to its customers and then trace the financial effects back to your returns as an investor.

  1. HTLD VL
  2. JBHT VL
  3. KNX_VL

Buy-Back Mania (a yellow light of caution) Stock Buybacks Hit RecordTotal 2 Trillion Since 2009

Emultate Henry Singleton

Case Study in capital allocation: Dr. Singleton and Teledyne A Study of an Excellent Capital Allocator (must read!)

Gold is in a hyper bubble……………….

Gold Bubble

But now not so much…………………Gold Bubble Not Quite as much

Gold is stupid-cheap compared to all the money out there…………………Gold hyper undervalued

What determines the price of gold

2010-06-21 IE Special Report GOLD

A Case Study in investing in Closed-End Funds

Prof. Greenblatt once said that sometimes people just go crazy.

A Lesson in CEF Investing TRF


Investors ran to pay a 90% PREMIUM to NAV AFTER a six-year boom and now after a seven-year decline they sell at a 10.5% DISCOUNT. Go figure.

Interesting video on China–a country brimming with centrally planned mal-investment. Is China Already in a Hard Landing?

Read more at reality-check-how-fast-is-china-growing.

We will get back to Deep Value next week and I will post links to valuation class videos.  Have a great weekend and if you do try to emulate someone, then:

ROIC and Reversion to the Mean



If women ran the world we wouldn’t have wars, just intense negotiations every 28 days. –Robin Williams

Return Measures by Damordaran 2007 (More on ROIC)


This is a key concept to learn along with EV/EBITDA, MCX, and cheapness wins.

REGRESSION TO THE MEAN  A good read by an Australian Graham & Dodd-like Investor.

When an investor turns to the research on regression to the mean and investors overreacting to poor company performance/bad news in Richard Thaler research, he or she sees that prices of the winner and loser portfolios take three-to-seven years to revert.  See also The New Finance: The Case Against Efficient Markets by Robert A. Haugen and Inefficient Markets by Andrei Schleifer.


Illustration by S of Reversion to the Mean

t is it a Goode value

We next progress to Chapter 5: A Clockwork Market, Mean Reversion and the Wheel of Fortune in Deep Value.

From there we will read chapters 3 and 4 in Quantitative Value.


Questions on Chapter 4

ABOOK-Feb-2015-Buybacks (1)

The Acquirer’s Multiple Ch 4 in DEEP VALUE  is where we left off in discussing Chapter 4.

Imagine diligently watching those stocks each day as they do worse than the market average over the course of many months or even years….The magic formula portfolio fared poorly relative to the market average in five out of every 12 months tested. For full-year period…failed to beat the market average once every four years. Joel Greenblatt discusses the role that loss aversion plays in deterring investors from following his ‘magic formula’. (Montier)

A Summary

Greenblatt reinterpreted Buffett’s return on equity capital measure as RETURN ON CAPITAL, which he construed as the ratio of pre-tax operating earnings (earnings before interest and taxes, or EBIT or EBITDA-MCX or operating earnings that are sustainable) to tangible capital employed in the business (Net Working Capital + Net Fixed Assets) defined as:

Return on Capital = EBIT divided by (Net Working Capital (NWC) + Net Fixed Assets)

The use of EBIT makes the return on capital ratio comparable across different capital structures. EBIT makes an apples-to-apples comparison possible.

For tangible capital Greenblatt uses NWC + Net Fixed Assets rather than total assets to determine the amount of capital each company actually requires to conduct its business.

The higher the return on capital ratio, the more wonderful the company.

To determine a fair price, Greenblatt uses earnings yield, which he defines as follows:

Earnings Yield = EBIT divided by Enterprise Value (EV).

EV gives a more full picture of the actual price an acquirer must pay than market capitalization alone.  EBIT is agnostic to capital structure so we can compare companies on a like-for-like basis.

The higher operating earnings are in relation to enterprise value, the higher the earning yield, and the better the value.

Greenblatt has quantified Buffett’s wonderful company at a fair price strategy.

Enterprise Multiple (EV) = EBITDA divided by EV or (EBITDA – Maintenance Capital Expenditures) divided by EV.


The EV to EBITDA ratio is useless without a discussion on asset lives, capital intensity, technological progress or revenue recognition.

EBITDA, or any of its derivatives (EBDIT, EBITDAR, etc.) is simply a crude measure of gross cash flow.

The gross cash flow margin is simply a measure of the capital intensity of the business.   A manufacturing business will have a significantly higher gross cash margin than, say, a retailer, because it needs to pay for the capital (via in the accounting sense the depreciation charge) of all its plant and equipment which consumes more of it than a superstore.

What matters is not gross cash flow but net of free cash flow, which is the amount of cash available after reinvestment.

Case Study:

In the heyday of the technology bubble, the EV to EBITDA ratio was a favorite among telecom analysts.   Sadly, as new entrants came into the system and pushed up the price of the UMTS licenses (the third generation of mobile networks) to insane levels, the cost of replacement went sky-rocketing; expected free cash flow plummeted, and the telecom shares got more and more ‘attractive’ on an EBITDA basis, which could not capture any of this.   Eventually, some went bankrupt, some had to undergo a debt rescheduling exercise or issue new capital, and all saw their share price collapse.

James Murray Wells, a 21-year-old law student in Bristol, UK, needed a pair of glasses, and was faced with a bill of 150 stg.   He found that the manufacturing cost off standard spectacles (frame and glasses) was less than 10 stg.   This prompted Mr. Murray Wells to set up an Internet-based company to challenge what he claimed was a lack of price competition among the four major high street opticians in England.  Three months into his venture, he was selling hundreds of pairs for as little as 15 stg to apparently delighted customers.

The replacement value of the asset, ‘making spectacles and selling them’ is rather low.   A 21-year old student with no expertise in the field is apparently able to replicate it from his student room, with a few thousand pounds borrowed from his father.   On the other hand, the market value is enormous because, as previously discussed, it equals the net present value of free cash flow discounted to infinity.

The market value is a direct function of the economic profitability of the asset in question and, in this example with a cost of goods sold at 10 and sales at $150, it is plain that economic value added is truly staggering.   Making spectacles and selling them has a high ROIC, and an equally impressive asset multiple—the ratio of market value to the replacement value of invested capital.

If the entrepreneur is successful in his venture, he will collapse the marginal return on capital invested of the industry by accepting a lower margin than his competitors.   The entrepreneur made an arbitrage between the market value of existing capacity and the replacement value of new capacity, which he found cheaper to create.

Investors in incumbent firms my find out that they have paid too much for the economic value of their asset in the belief that a very high economic return on capital invested was sustainable.   Investors who ignore the workings of the capital cycle, the ultimate driver of share prices, do so to their disadvantage.

Investment should just be a replication of the process of arbitrage between market value and replacement value. Good stock pickers are brilliant strategy analysts.   They understand the business case for the company. (TATOO that to your forehead!)


Why is the EV so good at identifying undervalued stocks?

What drives the returns of the magic formula? What Metric?  What does this mean for us as Deep Value Investors?

Assuming you read the entire chapter, what two main points about investing did you learn?  Anything surprise you?

Supplementary Readings:

What Has Worked in Investing by Tweedy Browne   Why do low price-to-book, low price to cash flows, etc tend to generate higher returns than a market average?  What is the principle behind the returns?  Also, note the Richard Thaler link below for a hint.

When an investor turns to the research on regression to the mean and investors overreacting to poor company performance/bad news in Richard Thaler research, he or she sees that prices of the winner and loser portfolios take three-to-seven years to revert.  See also The New Finance: The Case Against Efficient Markets by Robert A. Haugen and Inefficient Markets by Andrei Schleifer.

Next, we will focus on Mean Reversion and ROIC.

Death Taxes and Reversion To The Mean (Mauboussin)


Dale Wettlaufer on ROIC and MROIC  a series of articles

EconomicModel of DFC_ROIC The author uses NOPAT (after-taxes). I placed this here for those who wanted to see how others determine value.

We will review the second half of the chapter next.