Mar 3, 2009

When Joel Greenblatt described the Magic Formula Investing (MFI) strategy in his book The Little Book that Beats the Market . one of the most useful decisions he made was to use a companys enterprise value instead of market capitalization when calculating the earnings yield used to find cheap stocks. While most investors rely on metrics such as price-to-earnings (P/E, the inverse of earnings yield) and price-to-book (P/B), they would be better served concentrating on the enterprise value to earnings (EV/E) or enterprise value to book (EV/B). But why? What value does using enterprise value give us over using market capitalization to calculate these valuation metrics? And how do we get enterprise value as used by MFI?

Lets start by examining the how first, as it will help to explain the why. The MFI formula for calculating enterprise value is:

Enterprise Value = Market Capitalization + Total Debt — Excess Cash

Most of this is straightforward. Market Capitalization is simply share price * number of shares, and is widely available. Total debt is all long and short term debt obligations from the balance sheet. The last operand, Excess Cash, deserves a little explanation as it requires a bit of calculation. The idea is to use only the portion of the companys cash holdings that is not required to meet short term liabilities, should the need arise. Therefore, the calculation looks like:

Excess Cash = Total Cash — (Current Liabilities — Current Assets — Total Cash)

If Current Non-Cash Assets cover Current Liabilities, then Excess Cash is just the cash holdings with no adjustments. I know this is a bit confusing but it makes sense with a little thought. For example, if you have $500 in cash but need to pay a $100 credit card bill tomorrow, really you only have $400 in excess cash that you can freely spend.

So thats the how part. Now, the why part. Clearly, using enterprise value instead of market capitalization to calculate valuation statistics provides significant value, because it penalizes companies with a lot of debt and low cash balances, while rewarding companies with low debt and lots of cash. These low-debt, high-cash companies are higher quality as they can more easily survive an economic downturn or business problems, and have more flexibility in how to reward shareholders. With lots of cash and little debt, the company can pursue growth through new business lines or acquisitions, and can afford to buy back more shares or pay a higher dividend. On the other hand, those with high debt and low cash suffer the loss of profits through interest payments, and are also at risk of bankruptcy if business goes south and they can no longer afford to cover interest obligations.

Perhaps the usefulness of enterprise value is best illustrated by example. Lets take two recent Magic Formula stocks, one that has a lot of cash and little debt, the other with lots of debt and little cash. First, lets use the traditional Market Capitalization valuation: