1. Return on Capital
EBIT/ (Net Working Capital + Net Fixed Assets)
Our second part on calculating magic formula numbers is how to calculate return on capital. The first was calculating earnings yield. In simple terms, return on capital measures how much capital is need to conduct the company’s operations or business. And like Earnings Yield, we use a simple back of the envelope calculation using free resources. In this case, net working capital is simply Current Assets -Current Liabilities. Net Fixed Assets is simply Plant, Property & Equipment or commonly known as “PP&E”.
We will continue with our Lorillard example in which it has EBIT of 1.629 billion. We will then go to the company’s balance sheet to get out necessary data.
Current Assets: 2.504 Billion
Current Liabilities: 1.786 Billion
PP&E: .238
So our math looks something like this: (2.504-1.786) +.238 = .956
So now we simply divide our 2 numbers to arrive at return on capital.
1.629/ .956 = 170.40%
A return on capital of 170% is a bit high. From experience, many of the magic formula stocks have return on capital numbers of 20%+ and sometimes in the hundreds but once we get into the 150%+ numbers, we have to ask ourselves why this number is high. In this example, there isn’t a lot of PP&E invested in the business. 238 million worth of equipment is producing 1.659 billion worth of operating income. Not a bad business to be in. And historically, tobacco companies have been high return on capital businesses. For example, another large tobacco company Phillip Morris International (PM) has return on capital of 104%.
Putting the two numbers together we arrive at whether the business is worth investing our money into. It tells us how much the business earns relative to the current valuation and how much it earns on tangible capital. The best part about doing these calculations is that you could literally do them on the back of an envelope without using any Greek letters and complicated math.
