In my introduction to the Magic Formula, we learned that the screen is made up of two components. The first being the company’s earnings yield and the second being its return on invested capital, or simply ROIC. For this article, I focus on earnings yield, the importance of it and how to calculate it.
Earnings Yield Definition
The earnings yield shows us in percentage terms how much a certain company earns in relation to its current price. Traditionally, it is referred to as the inverse of the price-to-earnings ratio (P/E) or E/P.
But it is quite different in the magic formula as Joel Greenblatt (Trades, Portfolio) uses the following formula:
EBIT/Enterprise Value (EV)
The Importance of Earnings Yield
So why is the earnings yield so important? For a couple of reasons. First, it allows us to see how cheap a stock currently is. Unlike a discounted cash flow analysis, calculating a stock’s current earnings yield requires no estimates into the future.
The earnings yield also allows us to compare stocks versus other assets such as corporate bonds and Treasury bills. Lately we have been in a low interest environment, so it has been a “no brainer” to invest in stocks. But there will come a time when interest rates will rise and the interest rate gap will narrow.
Finally, and this is why I use earnings yield as my main valuation tool, you can apply it to any profitable company. Not only that, you can compare the earnings yield of two companies to see which one is cheaper.
Calculating Earnings Yield
Calculating earnings yield is very simple and takes no more than five minutes. I use a "back of the envelope" calculation and then compare it to GuruFocus’ figure. For this exercise I will be calculating the earnings yield of McDonald’s (MCD, Financial). I figured it’s a non-magic formula stock, not known, and a company I have no shares in.
EBIT/Enterprise Value
The first figure we need is EBIT, or pre-tax income, which could be found on any income statement. Joel Greenblatt (Trades, Portfolio) uses last year’s figures, but I like to use the trailing 12 months (ttm), it’s simply a personal preference. In McDonald’s case, it earned $8.205 billion in pre-tax income .
Now we need the enterprise value which takes a little bit more work but is not hard. Below is the information we need:
- Market Cap
+ Long-Term Debt
- Total Cash & Equivalents
Keep in mind, I use a back of the envelope calculation. If you want to go into detail, you would take into account minority interest and preferred shares.
So here are the figures I get for McDonalds:
Market Cap: $95.62 billion
L/T Debt: $14.130 billion
Cash & Eq.: $(2.799 billion)
EV=106.95
Now we simply divide the two and we get our earnings yield.
8.205/ 106.95=
Earnings Yield = 7.67%
With an earnings yield of 7.67% McDonald’s is not exactly the cheapest stock that I have seen, but it’s certainly better than what banks are offering on a CD.
How does my back of the envelope calculation compare versus the number GuruFocus displays?
It’s pretty close. GuruFocus currently displays an earnings yield of 8.20%. As always, it doesn’t hurt to cross your t’s and dot your i’s.
