The Little Book That Still Beats the Market Chapter 3: Earnings Yield

"Earnings yield is simply how much a business earns relative to the purchase price of the business." — Joel Greenblatt

The Investment Context

The second half of the Magic Formula is designed to find a "cheap" price. Greenblatt measures "cheapness" using Earnings Yield.

Imagine you buy a small business for $1 million. If that business generates $100,000 in profit this year, your earnings yield is 10% ($100,000 / $1,000,000). If the business only generates $20,000, your yield is 2%. As an investor, you want the highest earnings yield possible. You want to pay the lowest price for the highest amount of earnings.

The Wall Street Translation

Wall Street usually relies on the Price-to-Earnings (P/E) ratio. Earnings Yield is essentially the inverse of the P/E ratio, but Greenblatt tweaks it to make it much more accurate by accounting for debt.

1. Enterprise Value: Instead of just using the stock price (Market Capitalization), Greenblatt uses Enterprise Value (Market Cap + Debt - Cash). If you buy a company, you also assume its debt. A company might look cheap based on its stock price, but if it has massive hidden debt, the earnings yield is actually terrible.
2. EBIT vs. Net Income: Instead of using Net Income (which can be distorted by debt interest payments and taxes), Greenblatt uses EBIT (operating profit). This allows you to compare the pure earning power of different companies, regardless of how they are financed or what their tax rate is.
3. The Ranking System: Just like ROC, the Magic Formula calculates the Earnings Yield (EBIT / Enterprise Value) for every stock and ranks them from 1 to 3,500. The cheapest company gets a rank of 1.

Actionable Trading Rules

1. Combine the Ranks: The "magic" happens when you combine the two ranks. If a company ranks #150 in ROC (it's a great business) and ranks #50 in Earnings Yield (it's very cheap), its combined score is 200. You buy the companies with the lowest combined scores.
2. Compare to the Risk-Free Rate: An Earnings Yield is only attractive relative to the risk-free rate. If a 10-year Treasury bond pays 5% guaranteed, an Earnings Yield of 6% on a risky stock is terrible. You should demand an Earnings Yield that is at least double the risk-free rate.
3. Watch Out for Cyclicals: A company at the absolute peak of an economic boom might have massive, temporary earnings, giving it a high Earnings Yield. Be cautious when applying the formula to highly cyclical industries like homebuilders or steel manufacturers.