I didn’t even know that this was a ratio, until I read about it over the weekend, but it makes sense and looks useful, and so I am immediately promoting it to key ratio status. If you are wondering what the justification for the Mickey Mouse picture is, well, it is more to do with the magic than the mouse; this ratio is apparently similar to one used by Joel Greenblatt as part of his irritatingly-named, but highly thought of magic formula. I haven’t read his little book that beats the market yet, but I undertake to do so when I have a little time.
Why another type of earnings yield?
The theory behind this calculation (whether the authentic JG version or not) is to test for cheapness by measuring the return in profit before interest and tax as a percentage of a proxy purchase price of the whole business including debt. (I looked at the more conventional and simple version of an earnings yield here.)
How do you calculate it?
This is the recipe:
Earnings Yield = EBIT / Enterprise Value
These are the ingredients:
EBIT = Earnings Before Interest and Taxes, which is a company’s profit before payment of taxes or interest on debt. This is calculated by subtracting operating expenses + non-operating income (where present) from operating revenue (see Wikinvest).
Enterprise Value = This is a measure of the theoretical takeover price of a company. Investopedia says that it is calculated as: Market Cap + Debt + Minority Interest + Preferred Shares – Total Cash and Cash Equivalents.
There is a more comprehension version of this calculation, which includes pension deficits or unfunded liabilities and capital leases, described here. Alternatively, for the less intrepid, Yahoo Finance provides the figure on its Key Statistics page.
Taking it for a test drive
Here is the formula tested with IBM’s numbers:
EBIT = 48,370 (operating revenue) – 30,297 (total operating expenses) + 1,238 (Other income) = $19,311 m
Enterprise Value (millions) = 189,800 (market cap) + 6,862 (short-term debt) + 32,856 (long-term debt) + 137 (minority interest) – 10,716 (cash and cash equiv.) – 350 (short-term investments) = $218,589m
Note that IBM does not seem to have any preferred stock outstanding.
So, 19,311/218,589 = 0.088 = a pre-tax, pre-interest earnings yield of 8.8% on the theoretical purchase price of IBM.
How about another company, perhaps one with plenty of debt – Kellogg? Using the new formula we have: EBIT of 2,969 and EV of 30,847, which indicates an earnings yield of 9.6%. This looked highly suspiciously high to me and, after a quick search on the Web, I found an article which suggests the mark-to-market effect of Kellogg’s pension assets valuation is counted as operating income.
The Kellogg test drive highlights the dangers of using this formula without a seat belt. Neither does EBIT/Enterprise Value tell you anything about the future prospects for the business in the real world (away from the counting house). But, if not by itself quite magical, it does have its good points. Recognising debt, in particular, must make the indicated earnings yield more sensible.